INTERNATIONAL FINANCE UNIBO BELLETTINI - part 2, Slide di Finanza

Scarica INTERNATIONAL FINANCE UNIBO BELLETTINI - part 2 e più Slide in PDF di Finanza solo su Docsity! Lecture 7: Alternative exchange rate regimes. The trilemma Alternative exchange rate regimes * Foating exchange-rate regime: the value of the currency changes according to fluctuations in the supply and demand of the currency. No Central Bank intervention. * Fixed exchange-rate regime: Central bank intervenes to stabilize the exchange rate at a pre-announced level. In practice, Central Banks buy (or sell) any necessary quantity of foreign currency, increasing ( or decreasing) t heir official reserves, offsetting t he pressures on t he exchange rate. Spot rates: supply Equilibrium Dr I Spot rates: demand Floating (b) inereaso in supply se Di Quanti of cs ° Gi 05 Guantivat ts Quanti ot cs A 9 Quentivotea : a What Is a Fixed Exchange Rate Regime? * Here we focus on the case of a fixed rate regime without capital controls so that capital is mobile and arbitrage is free to operate in the foreign exchange market. * Central bank buys and sells foreign currency at a fixed price, thus holding the market exchange rate at a fixed level — denoted by E. * We examine the implications of Denmark”s decision to peg its currency, the krone, to the euro at a fixed rate: EDKr/€ * The Foreign country remains the Eurozone, and the Home country is now Denmark. * In the long run, fixing the exchange rate is one kind of nominal anchor. * Even if it allowed the krone to float but had some nominal anchor, Denmark”s monetary policy would still be constrained in the long run by its chosen nominal target. * What we now show is that a country with a fixed exchange rate faces monetary policy constraints not just in the long run but also in the short run. Pegging Sacrifices Monetary Policy Autonomy in the Short Run: Example The Danish central bank must set its interest rate equal to i€, the rate set by the European Central Bank (ECB): Efkrje — Eperse ingr = ie+ PELO Lig ipur/e Equals zero fora credible fixed exchange rate Denmark has lost control of its monetary policy: it cannot independently change its interest rate under a peg. M sb pen 3 PoevLpew (ink) Yoew = Poentex(ie)Ypev Our short-run theory still applies, but with a different chain of causality. * Under a float: o The home monetary authorities pick the money supply M. o In the short run, the choice of M determines the interest rate i in the money market; in turn, via UTP, the level of i determines the exchange rate E. o The money supply is an input in the model (an exogenous variable), and the exchange rate is an output of the model (an endogenous variable). * Under a fix, this logic is reversed: o Home monetary authorities pick the fixed level of the exchange rate E. o In the short run, a fixed E pins down the home interest rate i via UIP (forcing i =i*); in tum, the level of i determines the level of the money supply M necessary to meet money demand. o The exchange rate is an input in the model (an exogenous variable), and the money supply is an output of the model (an endogenous variable). Role ore Cont rega Cuor ca Cunent tvel trent eve Storm mod of cent cane te " “mec tir (cent period A Complete Theory of Fixed Exchange Rates: (GERE sorio nera Reti. | Same Building Blocks, Different Known and rt Fab GIRO) nelTow= bei foa nia interest Nonivalntevet rt, Unknown Variables dm î s È Lain Fi, pr Unlike in Figure 4-11, omonime to the home country is now Sere assumed to fix its exchange rate with the forei; DI Monetary Apprecch = I: torgrin modelo) ft change te "ze oi Da The levels of real ‘Telo cttne 51 (ire et)” — | gu n d î fi n pennone Balizne Kee ergii Rates. | income and the fixed I E exchange rate determine e OUR the home money supply dei is levels, given outcomes ritiro: Pei MoAaali TE FESTE rota Pe e Tr sare 1 Cena? copri in the foreign country. Pegging Sacrifices Monetary Policy Autonomy în fre Long Run: Example The price level in Denmark is determined in the long run by PPP. But if the exchange rate is pegged, we can write long-run PPP for Denmark as: Bic DEN 'pkere Peus With the long-run nominal interest and price level outside of Danish control, monetary policy aulonomy is impossible. We iper = fe and Pory = Epiyse Peva into Denmark's long-run money market cquilibrium to obtain: M nex = Poiew Tone Gpx+VYpew = Enkere Peun line Ge Vbex just substitute ie Our long-run theory still applies, but with a different chain of causality. * Under a float: o The home monetary authorities pick the money supply M. o In the long run, the growth rate of M determines the interest rate i via the Fisher effect and also the price level P; in tum, via PPP, the level of P determines the exchange rate E. o The money supply is an input in the model (an exogenous variable), and the exchange rate is an output of the model (an endogenous variable). * Under a fix, this logic is reversed: o Home monetary authorities pick the exchange rate E. o In the long run, the choice of E determines the price level P via PPP, and also the interest rate i via UIP; these, in tum, determine the necessary level of the money supply M. o The exchange rate is an input in the model (an exogenous variable), and the money supply is an output of the model (an endogenous variable). Consider the following three equations and parallel statements about desirable policy goals 1 E E, A fixed exchange rate fare "Fugzie Sg Afro e ec + May be desired as a means to promote is stability in trade and investment 2 Monetary policy qutonomy * May be desired as a means to manage the « Represented here by zero expected H ARES i [ome economy's business cyele lepreciation È erse — Eos !ternational capital mobility *_Represented here hy the ability to set the tane = le+" Ericore + May ho desired as a means lo promote Home interest rate independently of the integration, cfficieney, and risk sharing forcion intcrestrate + Represented here by uncovered interest parity, which results from arbitrage Simple Criteria for a Fixed Exchange Rate * Our discussions about integration and similarity yields the following: o As integration rises, the efficiency benefits of a common currency increase. o As symmetry rises, the stability costs of a common currency decrease. * The key prediction of our theory is this: pairs of countries above the FIX line (more integrated, more similar shocks) will gain economically from adopting a fixed exchange rate. Those below the FIX line (less integrated, less similar shocks) will not. FIGURE 8-4 (1 of 2) FIGURE 84 (2 af 2) Symmetry-Integration Diagram Symmetry-Integration Diagram Symmetry of shocks FENDI Cie: Neighsomhoods Symmetry of shacks ee Reino sg Ael Regon — vibo miti cy Voy nell Regions withina Wibinmcià snai rtsgted vittima integrated uithina | region fiing ave peste Star Net brit of sr tO, TE tre 0 ie countrio Fig ae poste ca, ‘bove the FI ln. countri Net beni cf fina are negative below te FD Ue, net denefts of integrated and/or Foot integiateò Siae and/or se miao covntris countries Market integration r Market integration Points 1 to 6 in the figure represent a pair of locations. Suppuse une location is i consideriny pegging ils exchange rate tu ils partner. ll'incir markets become more | I'the pair moves far enough up or to the right, then the benefits of fixing exceed costs integrated (a move to the right along the horizontal uxis) or if ihe economic shucks | (net benefits are positive). and the pair will cross the fixing threshold shown by the they experience become more symmetric (a move up on the vertical axis), the net | FZYline. Below the line, it is uptimal for the region to Alvat. Above the line, it is economic benefits of fixing increase. optimal for the region to fix. APPLICATION - Do Fixed Exchange Rates Promote Trade? Probably the single most powerful argument for a fixed exchange rate is that it might boost trade by eliminating trade hindering frictions. Benefits Measured by Trade Levels * AII else equal, a pair of countries adopting the gold standard had bilateral trade levels 30% to 100% higher than comparable pairs of countries that were off the gold standard. * Thus, it appears that the gold standard did promote trade. * What about fixed exchange rates today? Do they promote trade? Economists have exhaustively tested this hypothesis. APPLICATION Do Fixed Exchange Rates Promote Trade? In a recent study, country pairs A-B were classified in four different ways: a. The two countries are using a common currency (i.e., A and B are in a currency union or A has unilaterally adopted B°s currency). b. The two countries are linked by a direct exchange rate peg (i.e., A°s currency is pegged to B's). c The two countries are linked by an indirect exchange rate peg, via a third currency (i.e., A and B have currencies pegged to C but not directly to each other). d The two countries are not linked by any type of peg (i.e., their currencies float against one another, even if one or both might be pegged to some other third currency). FIGURE Lume of trad Do Fixed Exchange Rates Vola oi al: Promote Trade? Aoating exchange The char' shows one study rateregime io, Ce trae {so trade volumes of various types @ TEEN] offixed exchange rate “0 regimes, relative to a floating “ E ae = an Indirect pegs were found lo have a small but statistically insignificanti impact on trade, = but trade inercased under a tndiect pe Direct es Surerasunion | direct peg by 21%, and under Exchange rate regime a currency union by 38%, as compared to floating. APPLICATION Do Fixed Exchange Rates Promote Trade? Benefits Measured by Price Convergence * Studies that examine the relationship between exchange rate regimes and price convergence use the law of one price (LOOP) and purchasing power parity (PPP) as benchmark criteria for an integrated market. * If fixed exchange rates promote trade then we would expect to find that differences between prices (measured in a common currency) ought to be smaller among countries with pegged rates than among countries with floating rates. * In other words, under a fixed exchange rate, we should find that LOOP and PPP are more likely to hold than under a floating regime. When a country pegs, it relinquishes its independent monetary policy: it has to adjust the money supply M at all times to ensure that the home interest rate i equals the foreign rate i * (plus any risk premium). The Trilemma, Policy Constraints, and Interest Rate Correlations To solve the trilemma, a country can do the following: 1. Opt for open capital markets, with fixed exchange rates (an “open peg”). 2. Opttoopen its capital market but allow the currency to float (an “open nonpeg”). 3. Opt to close its capital markets (“closed”). res II (a) Open and Pegged (b) Open and Not Pegged (c) Closed change -5% interest rate Change +5% Change 5% interest rate ” 5 vo s vi ss Ò Change in base country Change in basa country Change in base country interest rate interest rate interest rate The Trilemma in Action The trilemma says that ifthe home country is an open peg. it sacrifices monetary policy autonomy because changes in its own interest rate must match changes in the interest rate of the base country. Panel (a) shows that this is rhe case. The trilemma also says hat. there are two ways to get that autonomy back: switch o a floating exchange rate or impose capital controls. Panels (b) and (c) show that cither of these two policies permits home interest rates to move more independently of the base country. Costs of Fixing Measured by Output Volatility * AII else equal, an increase in the base-country interest rate should lead output to fall in a country that fixes its exchange rate to the base country. * In contrast, countries that float do not have to follow the base country’s rate increase and can use their monetary policy autonomy to stabilize. * One cost of a fixed exchange rate regime is a more volatile level of output. 2 Other Benefits of Fixing * One common argument in favor of fixed exchange rate regimes in developing countries is that an exchange rate peg prevents the government from printing money to finance govemment exp enditure. * Under such a scheme, the central bank is called upon to monetize the government’s deficit (i.e., give money to the government in exchange for debt). This process increases the money supply and leads to high inflation. * The source of the govemment’s revenue is an inflation tax (called seigniorage) levied on the members of the public who hold money. The Inflation Tax * At any instant, money grows at a rate AM/M = AP/P=7. * If a household holds M/P in real money balances, then a moment later when prices have increased by x, a fraction x of the real value of the original M/P is lost to inflation. The cost of the inflation tax to the household is x x M/P. * The amount that the inflation tax transfers from household to the government is called seigniorage, which can be written as: Scigniorage= x x e =nxL(r° +7)Y Re e Inflation tax Taxrae a Tax fase * If a country”s currency floats, its central bank can print a lot or a little money, with very different inflation outcomes. * If a country’s currency is pegged, the central bank might run the peg well, with fairly stable prices, or run the peg so badly that a crisis occurs, the exchange rate ends up in free fall, and inflation erupts. * Nominal anchors—whether money targets, exchange rate targets, or inflation targets—imply a “promise” by the government to ensure certain monetary policy outcomes in the long run. * However, these promises do not guarantee that the country will achieve these outcomes. * The lesson: it appears that fixed exchange rates are neither necessary nor sufficient to ensure good inflation performance in many countries. The main exception appears to be in developing countries beset by high inflation, where an exchange rate peg may be the only credible anchor. Liability Dollarization, National Wealth, and Contractionary Depreciations * The Home country's total external wealth is the sum total of assets minus liabilitics expressed in local currency: W=(Ay+E4;)-(Ly+ELs) CAriZERA SOI Aste Liubifiios + A small change AF in the exchange rato, all else equal, affeets the values of Z4; and EL, expressed in local currency. We can express the resulting change in national wealth as. L.] e AW= AE x la, NelistenaGamni e Jordi) Destabilizing Wealth Shocks * It is easy to imagine more complex short-run models of the economy in which wealth affects the demand for goods. For example, o Consumers might spend more when they have more wealth. In this case, the consumption function would become C(Y — T, Total wealth). o Finms might find it easier to borrow if their wealth increases. The investment function would then become I(i, Total wealth). * If foreign currency external assets do not equal foreign currency external liabilities, the country is said to have a currency mismatch, and exchange rate changes will affect national wealth. o If foreign currency assets exceed foreign currency liabilities, the country experiences an increase in wealth when the exchange rate depreciates. o If foreign cumency liabilities exceed foreign currency assets, the country experiences a decrease in wealth when the exchange rate depreciates. * In principle, if the valuation effects are large enough, the overall effect of a depreciation can be contractionary! Original Sin * In the long history of intemational investment, one constant feature has been the inability of most countries—especially poor countries—to borrow from abroad in their own currencies. * The term original sin refers to a country's inability to borrow in its own currency. * Domestic currency debts were frequently diluted in real value by periods of high inflation. Creditors were then unwilling to hold such debt, obstructing the development of a domestic currency bond market. Creditors were then willing to lend only in foreign currency, that is, to hold debt that promised a more stable long-term value. * Habitual “sinners” such as Mexico, Brazil, Colombia, and Uruguay have recently been able to issue some debt in their own currency. * A more feasible—and perhaps only—alternative is for developing countries to minimize or eliminate valuation effects by limiting the movement of the exchange rate. o The lesson: in countries that cannot borrow in their own currency, floating exchange rates are less useful as a stabilization tool and may be destabilizing. This outcome applies particularly to developing countries, and these countries will prefer fixed exchange rates to floating exchange rates, all else equal. Symmetry-Integration Diagram Summary Symmetry of shocks * A fixed exchange rate may be the only transparent and credible way to attain and maintain a nominal anchor—which may be particularly important in developing countries with weak institutions and poor reputations for monetary stability. “A fixed exchange rate may also be the only way to avoid large fluctuations in external wealth, which can be a problem in countries with high levels of liability dollarization. * Such countries may be less willing to allow their exchange rates to float—a situation that some economists describe as a fear of floating. ft © otocingapnz Market integration A Shift in dhe FIX Line Additional benefits of îxing or higher costs of floating will lower the threshold for choosing a fixed exchange rate. The FIX line moves down. Choosing a fixed rate now makes sense, even at lower levels of symmetry or integration (c.g.. at point d Lecture 9: Fixed vs. floating: International monetary experiences 3 Fixed Exchange Rate Systems * Fixed exchange rate systems involve multiple countries. * Examples include the global Bretton Woods system in the 1950s and 1960s and the European Exchange Rate Mechanism (ERM) through ‘which all potential euro members must pass. * These systems were based on a reserve currency system in which there are N countries (1, 2, .. ., N) participating. * One of the countries, the center country (the Nth country), provides the reserve currency, which is the base or center currency to which all the other countries peg. * When the center country has monetary policy autonomy it can set its own interest rate i * as it pleases. * The other noncenter country, which is pegging, then has to adjust its own interest rate so that i equals i * in order to maintain the peg. * The noncenter country loses its ability to conduct stabilization policy, but the center country keeps that power. * The asymmetry can be a recipe for political conflict and is known as the Nth currency problem. * Cooperative arrangements can be worked out to try to avoid this problem Cooperative and Noncooperative Adjustments to Interest Rates Caveats * A unilateral peg gives the benefits of fixing to both countries but imposes a stability cost on the noncenter country alone. * The historical record casts doubt on the ability of countries to even get as far as announcing cooperation on fixed rates, let alone actually backing that up with true cooperative behavior. * A major problem is that, at any given time, the shocks that hit a group of economies are typically asymmetric. * The center country in a reserve currency system has tremendous autonomy, which it may be unwilling to give up, thus making cooperative outcomes hard to achieve consistently. * We can now see that adjusting the peg is a policy that may be cooperative or noncooperative in nature. * How did the world react to the collapse of the Bretton Woods system? o Some countries, both developed and developing, have camped in the middle ground: they have attempted to maintain intermediate regimes, such as “dirty floats” or pegs with “limited flexibility.” o Finally, some countries (e.g. China) still impose some capital controls rather than embrace globalization. The Rise and Fall of the Gold Standard The Rise and Fall of the Gold Standard FIGURE 8-14 (1 of 3) FIGURE 8-14 (2 0f3) Policy choice No monetary police sutonomy Soto gol 3 Lo al 1 nd £ ha oi choice No monetary policy sutonemy Safe gol 3 to atta ond 2 point mi ti i Capita moti Fined exchange rate. di DI Intendo dii È di Mi À A LA \ An el te to st mt rovina LR RE A SME regine N rey iste roiggea Poli chic fig dote poggi alc chel pag: tire) i anno Tore SE, non pl seno | ST Soci az eat sd 1 sos go Tin endk na Sane aL do st 3 nd 1 seus natio Zoni Tn the advanced countries, the trilemma was resolved by a shift to floating rates, which preserved autonomy and allowed for the present era of capital mobility (bottom right corner) In the 1960, (he Bretton Woods system became unsusluinable because capital mobility could nor contained. Thus, countries could no longer have fixed rates and monetary autonomy (bottom left commer). The Rise and Fall of the Gold Standard FIGURE 8-14 (2 01 3) capiti cono Senio gcL2 io oca 3 ord 1 l'he main exceplion was ihe currency union of the Furozone. In developing comiries and emergiag markets, the “fear of floating” was stronger; when capital markets were opened, monetary policy autonomy was more often sacrificed and fixed exchange rates were maintained (top corner). Lecture 10 - Exchange rate crises * The typical fixed exchange rate succeeds for a few years then breaks. A recent study found that the average duration of any peg was about five years. * When the break occurs, there is often a large and sudden depreciation. Such a collapse is known as an exchange rate crisis. * Understanding the causes and consequences of exchange rate crises is a major goal of international macroeconomics because of the damage they do. * There is an important asymmetry in regime changes: the shift from floating to fixed is generally smooth and planned, the shift from fixed to floating is usually unplanned and catastrophic. 1 Facts About Exchange Rate Crises * A simple definition of an exchange rate crisis would be a “big” depreciation. * In an advanced country, a 10% to 15% depreciation might be considered large. In emerging markets, the bar might be set higher, 20% to 25%. * Exchange rate crises can occur in advanced countries as well as in emerging markets and developing countries. * The magnitude of the crisis, as measured by the subsequent depreciation of the currency, is often much greater in emerging markets and developing countries. Causes: Other Economic Crises * Exchange rate crises usually go hand in hand with other types of harmful financial crises, especially in emerging markets. *If banks and other financial institutions face adverse shocks, they may become insolvent, causing them to close or declare bankruptey: this is known as a banking crisis. * In the public sector, if the government faces adverse shocks, it may default and be unable or unwilling to pay the principal or interest on its debts: this is known as a sovereign debt crisis or default crisis. International macroeconomists thus have three crisis types to consider: exchange rate crises, banking crises, and default crises. Evidence shows they are likely to occur simultaneously: * The likelihood of a banking or default crisis increases significantly when a country is having an exchange rate crisis. * The likelihood of an exchange rate crisis increases significantly when a country is having a banking or default crisis. These findings show how crises are likely to happen in pairs, known as twin crises, or all three at once, known as triple crises, magnifying the costs of any one type of crisis. 2 How Pegs Work: The Mechanics of a Fixed Exchange Rate * Let's assume home currency is the peso. The currency to which home pegs is the U.S. dollar, and we assume the authorities have been maintaining a fixed exchange rate, with E fixed at E (con _ sopra) = 1 (one peso per U.S. dollar). * The country’s central bank controls the money supply M by buying and selling assets in exchange for cash. The central bank trades domestic bonds (denominated in pesos), and foreign assets (denominated in dollars). * The central bank stands ready to buy and sell foreign exchange reserves at the fixed exchange. If it has no reserves, it cannot do this and the exchange rate is free to float: the peg is broken. * For now, we assume that the peg is credible. Uncovered interest parity then implies that the home and foreign interest rates are equal: * We will also assume for now that output or income is exogenous and denoted Y. * There is a stable foreign price level P* = 1 at all times. In the short run, the home country's price is sticky and fixed at a level P= 1. In the long run, if the exchange rate is kept fixed at 1, then the home price level will be fixed at 1 as a result of purchasing power parity. * The home country’s demand for real money balances M/P is determined by the level of output Y and the nominal interest rate i and takes the usual form, M/P=L(i)Y. The money market is in equilibrium. * There is no financial system and the only money is currency, also known as MO or the monetary base. The money supply is denoted M. We consider only the effects of the actions of a central bank. The central bank balance sheet * The home central bank”s sole liability is the money in circulation. * Suppose the central bank has purchased a quantity B pesos of domestic bonds. By, in effect, loaning money to the domestic economy, the central bank”s purchases are usually referred to as domestic credit created by the central bank. * These purchases generate part of the money supply and are also called the bank®s domestic assets. * The part of the home money supply created as a result of the central bank's issuing of domestic credit is denoted B. * Now suppose the central bank also uses money to purchase a quantity R dollars of foreign exchange reserves, usually referred to as reserves. * Because the central bank holds only two types of assets, the last two expressions add up to the total money supply in the home economy: M = B +R sa Sa fa 1) Money supply Domestic credit Resetves * lixpressed not in levels but in changes: AM = AB + 09) Change in Change in imge in money supply domestic credit reserves The central bank balance sheet contains the central bank”s assets, B + R, and the money supply, its liabilities. SIMPLIFIED CENTRAL BANK BALANCE SHEET (MILLIONS OF PESOS) Assets Liabilities Reserves & 500 Money supply: M 1,000 Foreign assets (dcller reserves) Currency în circulation Domestic credit 8 500 emestic assets (peso bons) We are assuming that the exchange rate is fixed if and only ifthe central bank holds reserves; and the exchange rate is floating if and only if the central bank has no reserves. How Reserves Adjust to Maintain the Peg * What level of reserves must the central bank have to maintain the peg? If the central bank can maintain a level of reserves above zero, we know the peg will hold. If not, the peg breaks. Solving for the level ofreserves: R=M — B *_ Since money supply equals money demand, given by M=PL(i)Y, then: R=PUY- 8 09 RESET rione Seneal- Domesliccrdi * If the central bank bought more reserves than required by Equation (9-3), home money supply would expand and the home nominal interest rate would fall, the peso would depreciate, and the peg would break. * To prevent this, the central bank would need to intervene in the forex market to offset its initial purchase of reserves, to keep the supply of pesos constant, and to keep the exchange rate steady. * Similarly, if the central bank sells reserves for pesos, it would cause the peso to appreciate and would have to reverse course and buy back the reserves. The peg means that the central bank must keep the reserves at the level specified in Equation (9-3). Central Bank Balance Sheet odi pei teso 3 Money supol, M This figure presents a simplified view of centra] bank operations. On the 45-degree line, reserves re at zero, and the money supply X equals domestic credit 8 Variations in the money supply along this line would cause the exchange rate to float. There isa unique level of the money supply M; (here assumed to be 1,000) that ensures the exchange rare is at its chosen fixed value. Graphical Analysis of the Central Bank Balance Sheet FIGURE 9-4 2012) Tha Cantral Bank Balance Sheet Diagram (continued) Central Bank Balance Sheet Domestic creo, 8 1 rr fai e teme o Money supp To fix the money supply ul this level, the central bunk musi choose a mix ol ussels on its balance sheet fhal comesponds to points on line XZ, points at which domestic credit 8 is les than money supply M. At point Z, reserves would be at zero; at point_X, reserves would be 100% of the money supply. Any point in between on AZ is a feasible choice. At point 1, for example, domestic credit is 8, = 500, reserves are R, = 500, and 2, +8, = 000. A fixed exchange rate that always operates with reserves equal to 100% of the money supply is known as a currency board system. To sum up: if the exchange rate is floating, the central bank balance sheet must correspond to points on the 45-degree floating line; if the exchange rate is fixed, the central bank balance sheet must correspond to points on the vertical fixed line Defending the Peg I: Changes in the Level of Money Demand We first look at shocks to money demand and how they affect reserves by altering the level of money supply M. A Shock to Home Output or the Foreign Interest Rate * Suppose output falls or the foreign interest rate rises. We treat either ofthese events as an exogenous shock, all else equal * Suppose the endogenous shock decreases money demand by 10% at the current interest rate. * A fall in the demand for money would lower the interest rate in the money market and put depreciation pressure on the home currency. To maintain the peg, the central bank must keep the interest rate unchanged. It must sell 100 million pesos ($100 million) of reserves, in exchange for cash. The central bank”s balance sheet will then be as follows: SIMPLIFIED CENTRAL BANK BALANCE SHEET AFTER. MONEY DEMAND FALLS (MILLIONS OF PESOS) Assets Liabitities Reserves R 400 Money supply M Foreign assets (Jollarreserves) Currency in circulation Domestic credit 8 500 Domestic assets (peso bonds) Centrat Bank Balance Sheet Tuo © Moneysuppiy. Ifmnoney dermund full interest rates tend to fu, leuding to pressure for an vxchiinge rate lo ae i io ore ti money supp. he buak bite o 0 cp ib inesst te fixed and to ensure that money supply cquals money dei here, the money supply deelines from Afj — 1,000 10 df, 900 TRES 649 RR III Centrat Bank Balance Sheet Rina re O posirive shock 13 shown hy the mave Sim point 1 to point 3, where 45 = 1,100 00. In a currency board «yslem. a country maintaining 100% reserves will be om the horizonta] ixis wilh zero domestic eredi, = 0. A currency board adjusts 10 money demand shocks by moving from poini l'o points 2° or 3°. 900 FIGURE 95 (2013) Shorkata Money Demand (continted) Central Bank Balance Sheet Domestic 1.600 eredi, 5 Loco rico fi i — Fin So orfototm00in i Lean Money suppl, M If domestie credit is unchanged at 8; — 500, the change in the central bank balance sheet is shown by a move from point | (o point 2, and reserve» absorò thc money demand shock by falling from R, — 500 to A, — 400. interest rate remain unchanged. * The central bank's balance sheet will then be as follows: SIMPLIFIED CENTRAL BANK BALANCE SHEET AFTER EXPANSION OF DOMESTIC CREDIT (MILLIONS OF PES05) Assets Liabilities Reserves R 400 Moneysuppiy M 1,000 Foreign assets (dollorreserves) Morer ia cieulation Domestic credit 8 500 Domestic a5ses (peso bond) * There is no change in monetary policy as measured by home money supply because the sale and purchase actions by the central bank are perfectly offsetting. * This type of central bank action is described as sterilization or a sterilized intervention, or a sterilized sale of reserves. rovi tà RRN rcce scs RR TI Central Bank Balance Sheet Central Bank Balance Sheet Domestic 1,600 credit. 8 500 1200 domestic 1 credit, 1 8,603) 600» tn a ent ue th __ Boch roi fly 50% (gin), steiatim a Laver vin 2) ore faina 3) the bat ro, 50% (po 7-10 Money supp, A FE = 1000" Money suppiy, M 1} domestie credit rises, money supply riscs, all else cqual, interest rates tend to fall, putting 1F domestic crei pressure on the exchange rate to depreciate. To prevent this depreciation, keep the peg, and to point 2, and 100. An opposite shock is shown by the stay on the fixed linc, the central bank must intervene and defend the peg by selling rescrves ve from poi and A; 600. IFthe country 100% t0 keep the money suppiy fixed. Ax shown here, the money sunpiy is Mj 1,000. serves, it has t0 stay at point 1": a currency board cannot engage in steriliz: 00, the balance sheet moves from point 1 * Sterilization is impossible in the case of a currency board because a currency board requires that domestic credit always be zero and that reserves be 100% of the money supply. * If the change in money demand is zero, then AM = 0; hence, the change in domestic credit, AB > 0, must be offset by an equal and opposite change in reserves, AR =-—AB < 0 (see Equations (9-2) and (9-3). * Holding money demand constant, a change in domestic credit leads to an equal and opposite change in reserves, which is called a sterilization. ‘Why Does the Composition of the Money Supply Fuctuate? Economists distinguish between banks that are illiquid and those that are insolvent. * Insolvency and bailouts. A private bank is insolvent if the value of its liabilities (e.g., customers” deposits) exceeds the value of its assets (e.g., loans, other securities, and cash on hand). * Illiquidity and bank runs. A private bank may be solvent, but it can still be illiquid: it holds some cash, but its loans cannot be sold (liquidated) quickly at a high price and depositors can withdraw at any time. FIGURE 00 (2012) [TRA Centi Rankin see cond) FI (b) Lender of Last Resort Operation (2) Financiat Sector Baitout Operation Central Bank Balance Sheet, Domestic 1.600 credit 1. fd ino shit tc demon for coin rise credit 8 i.500 Fc egli i Ro e dept o | A ii ceto 100 2, ie demon far moves s ivo 206 300 #00 330 05 RO 806 500 LODO 1.150 1305 32300 17400 1500 1600 ° asi Money suppis, M n Money supply, M Tn pane! (b), private bank depositors want to shift from hotdi In panel (a), a bailout occurs when the central bank prints money and buys domestic assets central bun sets as u lender of last resort and temporuzily the bad assets ol insolvent private banks. There is no change in demand for base money private banks, both the demand and supply of base money (cash) rise, so the level of reserves (cash), so the expansion of domestic credit Icads to a decrease off reserves. ir unchanged. ‘Why Does the Composition of the Money Supply Fuctuate? * If depositors fear that banks are either insolvent or illiquid, a bank run may occur, and if the problem spreads to other banks, the panic may lead to a flight from domestic deposits to foreign bank deposits. * As depositors demand foreign currency, they drain reserves and make it more likely that devaluation will happen. Devaluation leads to a higher-risk premium, worsening economic conditions and a flight from the currency APPLICATION - The Argentine Convertibility Plan After the Tequila Crisis - Banking Crisis, 1995 * After the Mexican Tequila crisis in December 1994, higher interest rates, a budget deficit, and damage to commercial banks” balance sheets, Argentina faced a banking crisis. * Reserves drained, casting more doubt on the viability of the fixed exchange rate, raising the currency premium, and draining more reserves. Given the fears of a banking crisis and exchange rate crisis, cash and bank deposits were switched into dollars and moved to banks in offshore locations. People were now starting to run from the currency, too. * The country was getting perilously close to the floating line, the dangerous place where reserves run out. The Argentine Convertibility Plan after the Tequila Crisis - Help From the IMF and Recovery * After the Tequila crisis, the United States advanced a large assistance package to Mexico, and the IMF took a more lenient view of the Argentine situation, fearing the possibility of a global financial crisis if Argentina crashed, too. * The economy recoveredì, capital flows resumed, and eventually the central bank’s emergency loans were paid back. * By 1996 economic growth had picked up, interest rate spreads eased, and confidence returned. EXPECTED PROFITS FROM SPECULATION WITH LOW BORROWING RATES ia 13 ssa 8% =“ evaluation 1.3 pesos per | USS ro devalstion arde ate i de arte 30 days 9 converts arl USS into 12 uil. pesos convert 12 mil USS into 12 mi. pesos Persa ta Usa adi: Sir ea e ali soste 300K USE int 1,20 il proe 30120 mi convert 80K LS$ into 120K pes ya 120 pus sie —_orpere SDK USE int 130 mil proe e i ome 6 USS cm US bond emme OR ISS om LIS hd me OK VSS 00 15 ho TTT SS 12-12-0.12+0.06= -0.06 tI A More General Balance Sheet GENERAL CENTRAL BANK BALANCE (MILLIONS OF PESOS) Assets Liabilities Foreign assets 950 Foreign liabitities 50 of which: af wttich: Foreign reserves (ali curencies) 950 | | Foreign currency debt issued by the 50 Golé 0 | centralbank Domestic assets 500 Domestic liabilities 400 of which: cfwtich: Domestic gevernment bonds bought 300 | omesticcurrengy debt issued bythe 400 Loans to commercial banks 200 | central bank Noney supply. M 1,000 af wttich: Currency in circulation 900 Reserve liabilities to commercial bans —100 In general, money supply is equal to net foreign assets plus net domestic assets. The only real difference is the ability of the central bank to borrow by issuing nonmonetary liabilities, whether domestic or foreign. Sterilization Bonds * What borrowing to buy reserves achieves is not a change in monetary policy (money supply and interest rates are unchanged, given the peg) but an increase in the backing ratio. * Sterilization is just a way to change the backing ratio, all else equal. * By issuing sterilization bonds, central banks can borrow from domestic residents to buy more reserves. With sufficient borrowing, the central bank can end up with negative net domestic credit and reserves in excess of the money supply. * This has happened in China in recent years. Two Types of Exchange Rate Crises = sv The central bank balence (a) Permanently Rising Domestic Credit rana (b) Temporary Expansion of Money Supply n pl Central bank balance sheet way to think about what Corta boni stanca hoc aclimiiparigy i actions will cause the Domestic romesti eis | |_ outing ue peg to break. Domestic] one po Fc e CI °° |. permanentty rising, credit, 8! temporarily rses, ri h then at some poînt Tn panel (a), a permanent exchange rate depreiates, depreciate the exchange reservs fall to zero, and ongoing expansion and ficed regime must rate, even if a reversal of mono sappi rtes > of domestic credit is give way to floating. this policy is expected in i incompatible with a N the finire. Rofh policies fixed regime gives fixed exchange rate take the country offthe way to floating. regime because, sooner fixed line and onto the or later, reserves will be floating line. reduced to zero, and then the money supply starts to expand. Fixeg fina, M Money supply, M Money supply, M Two Types of Exchange Rate Crises 3 How Pegs Break I: Inconsistent Fiscal Policies * We begin with a first-generation crisis model of inconsistent fiscal policies. * We assume that output is fixed, and we allow the price level to change, according to purchasing power parity (PPP). * The government runs a persistent deficit (DEF) and is unable to borrow from any creditor. It turns to the central bank for financing. * In this type of environment, economists speak of a situation of fiscal dominance in which the monetary authorities ultimately have no independence * Domestic credit B increases by an amount AB = DEF every period and is growing at a constant positive rate, AB/B = |. * Every change in the level of domestic credit leads to an equal and opposite change in the level of reserves. Reserves must eventually run out. * At that point, the peg breaks and the central bank shifts from a fixed exchange rate regime to a floating regime, in which the money supply equals domestic credit, M =B. * The crisis happens because authorities are willing to let it happen The Myopic Case (0 Hog ds Cie ad Rs ti po] An Exchange Rate Crisis Due to Inconsisteni Fiscul Policies: Myopie Case Tn the [un] regione, money 5 implica Cul mervas Rare Calling 0 2ero. Suppose Ue svi a Avatinu vccur when £ will ll grow ut constant rate (here, 10% per period). The Myopic Case FIGI An Fxchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic Cust Continued) The money supply does nor. adjust immediately; so this ‘jump in MP must be accommodated by a jump în prices R. (0) None, Bomest Cost, and Res: (ufth moto) To maintaia purchasino power parity, £ must also ‘jump at the seme time. Hence. myopic investors face a cnpitai loss on pesos ar rime 4 0) price vet an Echinge Rate (ut myooia) ri DD A simple model — a forward looking case How does this pin down the attack at time 2? because of overriding fiscal priorities. The Myopic Case Mon, Domani, nd earn pi) An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopio Cnse (costimu=d) Th expected rates of inflatiox and depreciution are now positive, and che Fistier effet tela us that tho interest inte mist june np at periodi di (Ly IU percentage posts) The interest rule increase mean that real money demand MP = L0)Y Falls nstanely at tin 4. € pico tanta e * At any time later than 2, there must be a jump up in the exchange rate, a discontinuous depreciation. If they wait to attack until time 3, peso FIGURE 9-17 (3 of 3) Zone Il is the gray area: if investors believe the peg is credible, costs are low and the peg will hold; if' investors believe the peg is noncredible, costs are higher and the peg will break. CE rog) >b> CF) noor & — Costs of pegging Cohen peg i: eredible) APPLICATION The Man Who Broke the Bank of England * Changes in market sentiment, often called “animal spirits,” emerge from a model based on rational actors. * In some circumstances, the instability problem is much worse than anticipated. One reason is that as the time frame shrinks, the cumency premium explodes. Another is how beliefs are formed in the first place. * Investor George Soros likes to use the term “reflexivity” to describe how markets shape events, as well as vice versa. * Soros’ firm borrowed billions of pounds and parked all the money in German mark deposits. “It was an obvious bet, a one-way bet,” he later recalled. * The Bank of England, under orders from the U.K. Treasury, was intervening furiously, selling marks to prop up the pound at the limits ofthe ERM band. * The sudden increase in the currency premium was inducing a massive reserve drain. On the morning of September 16, 1992, the pressure on the pound became intense. It was all over by lunchtime, with the bulk of the reserves lost, and an estimated £4 billion spent in a futile defense. Summary * Our results are striking. If government policies are contingent, then they will depend on market sentiment. But market sentiment, in tum, depends on what the market believes the government will do. * If costs of pegging are “low,” then pegs hold when they “should”—when the government has no desire to exit. If costs of pegging are “high,” then crises happen when they “should'”—when the government clearly wants to exit. * But in between these extremes, an ambiguity arises in the form of multiple equilibria because for some “medium” range of costs, a crisis occurs if and only if the market expects a crisis. 5 Conclusions In this chapter, we studied two kinds of fixed exchange rate crises. * Adverse fiscal conditions can send the money supply out of control. * And changes in the real economy can weaken the commitment to a peg. * Expectations matter in each case—shifts in investor sentiment can make the crises occur “sooner” (i.e., when economic fundamentals are better), leading to worries that some crises are an unnecessary and undeserved punishment. Can We Prevent Crises? Below are some of the proposed solutions. * The case for capital controls. For some examples (Malaysia after 1997, Spain after 1992), a case can be made that controls resulted in a positive difference in a time of crisis, but in large samples, the effects are weak or negative. * The case against intermediate regimes. Economists conclude that intermediate regimes are very risky. Countries should get out of the middle and move to the corners. This view came to be known as the corners hypothesis or the missing middle. In this “bipolar” view, only the two extremes of a hard peg or a true float were recommended. * The case for floating. There can be powerful reasons to peg if emerging markets have fear of floating, but empirically, the floating corner has not attracted all that many countries in practice. * The case for hard pegs. The lesson here is that all fixed exchange rates can end up being cheap talk, no matter how much armor they appear to have. * The case for improving the institutions of macroeconomic policy and financial markets. Improvements in the macroeconomic and financial structure in a country are the foundations on which any successful fixed exchange rate regime must be built. * The case for an international lender of last resort. The International Monetary Fund (IMF) can help countries in difficulty if it thinks they can restore stability in a timely fashion with the help of a loan. But making the right judgments is far from easy. Many worry that the prospect of IMF bailouts, like any kind of insurance, may encourage lax behavior (moral hazard), which could worsen the crisis problem. * The case for self-insurance. What if a country wants to peg, but none of the above ideas offers much comfort? What if controls are unattractive, floating too risky, and currency boards too much of a straightjacket? The vast reserve buildup of recent years may be seen as a giant exercise in saving for a rainy day to protect emerging market countries against the vicissitudes of global finance. Lecture 11: The Euro: costs and benefits of a common currency * The European Union (EU) is a mainly economic, but increasingly political, union of countries that is in the process of extending across the geographical boundaries of Europe. * The main impetus for the euro project came in 1992 with the signing of the Treaty on European Union, at Maastricht, in the Netherlands. * Under the Maastricht Treaty, the EU initiated a grand project of Economic and Monetary Union (EMU). “ A major goal of EMU was the establishment of a currency union in the EU whose monetary affairs would be managed cooperatively by members through a new European Central Bank (ECB). Different countries choose to participate in different aspects of economic and monetary integration, a curious feature of the EU project known as variable geometry. *As of 2021, the EU comprised 27 countries (EU-27). * A country can be in the EU but not in the Eurozone. It is important to remember who”s “in” and who's “out” * Those who wish to get “in” must first peg their exchange rates to the euro in a system known as the Exchange Rate Mechanism (ERM). 1 The Economics of the Euro * If countries make a decision that best serves their self-interest— that is, an optimizing decision—when they form a currency union, then economists use the term optimum currency area (OCA) to refer to the resulting monetary union. * To decide whether joining the currency union serves its economic interests, a country must evaluate whether the benefits outweigh the costs. Market Integration and Efficiency Benefits If there is a greater degree of economic integration between the home region (A) and the other parts of the common currency zone (B), the volume of transactions between the two and the economic benefits of adopting a common currency due to lowered transaction costs and reduced uncertainty will both be larger. Economic Symmetry and Stability Costs If a home country and its potential currency union partners are more economically similar or “symmetric” (they face more symmetric shocks and fewer asymmetric shocks), then it is less costly for the home country to join the currency union. | FIGURE 102 Symmetry-Integration Diagram The net benefits of adopting a common currency equals the benefits minus the Symmetry of shocks costs. The two main lessons we have just encountered suggest the following: * As market integration rises, the efficiency benefits of a common currency increase. *As symmetry rises, the stability costs of a common currency decrease. Unite) rd? "otros What's the Difference Between a Fix and a Currency Union? n 1 . . n . n A Citra To regine are nonsidering a comin ina. Imre become more * When countries consider forming a currency union, the economic tests (based |uiczrated (a move right 0% the horizontal a), th nei ccomorzie on symmetry and integration) set a higher bar than for judging whether it is |&5tenetesnone sente ot cinto catarsi incisa optimal to fix. * Denmark is in the ERM, so the krone is pegged to the euro, but not in the Eurozone. * Denmark appears to have ceded monetary autonomy to the ECB, but transactions between Denmark and the Eurozone still require a change of currency. * Denmark has the option to exercise monetary autonomy or leave the ERM at some future date if they want the flexibility of a more freely floating exchange rate. fs La cuereney union e (a move up le verscal is stima Se the parts of e regio to form a Iy 1 he shtove and o he righe afihe FD line * Italy is one of several countries in which rumors of departure from the Eurozone have surfaced from time to time. * An Italian exit from the euro would be difficult and costly. Reintroducing new lira as money would be difficult and all Italian contracts in euros would be affected by the “lirification” ofthe euro. * Other countries that have tried these kinds of strategies, such as “pesification” in Argentina and de-dollarization in Liberia, have resulted in economic crises. * Exit from a peg is not easy, but exit from a common currency is much more difficult. Other Optimum Currency Area Criteria Labor Market Integration * In the event of an asymmetric shock, labor market integration provides an alternative adjustment mechanism through migration Fiscal Transfers * A third adjustment channel is available if fiscal policy is not independent but built on top of a federal political structure with fiscal mechanisms that permit interstate transfers— known as fiscal federalism. * If Home suffers a negative shock, fiscal transfers from Foreign allow more expansionary fiscal policy in Home. If fiscal transfers result in gains for Home, there is a shift down from OCA1 to OCA2 in Figure 10-3. Symmetry-Integration Diagram Symmetry of shocks. Monetary Policy and Nominal Anchoring * If Home suffers from chronic high inflation that results from an inflation bias of Home policy, the more politically independent common central bank of the currency union could resist political pressures to use expansionary monetary policy for short-term gains. * Italy, Greece, and Portugal are Eurozone members that historically have been subject to high inflation. * High-inflation countries are more likely to want to join the currency union, the larger are the monetary policy gains of this sort. cher 0A cite change such ox benefit: no ns rose fa, She cha OA lin hf n Political Objectives * Finally, there is the possibility that countries will join a currency union even if it makes no pure economic sense for them to do so. * Forming a currency union has value for political, security, strategic, or other reasons. * Political benefits can be represented in Figure 10-3 by the OCA line shifting down from OCA1 to OCA2. * In this scenario, for countries between OCA1 and OCA2, there are economic costs to forming a currency union, but these are outweighed by the political benefits. APPLICATION - Optimum Currency Areas: Europe Versus the United States We can use comparative analysis to see if Europe performs as well as or better than the United States on each of the OCA criteria, which would lend indirect support to the economic logic ofthe euro. Goods Market Integration - As intra-EU trade flows rise further, the EU”s internal market will become more integrated, but on this test Europe is probably behind the United States (see panel (a) of Figure 10-4). Symmetry of Shocks - Most EU countries compare quite favorably with the U.S. states on this test. There is no strong consensus that EU countries are more exposed to local shocks than the regions of the United States (see panel (b) of Figure 10- 4). (b) Symmetry Criterion (Ficure 4a MM (@) Integration criterion — [FIGURE 104 (014 — MN i vetation 10 7 sn) OCA Criteria for the Eurozone and a] the United States (continued) sloalog the United States Most economists —€xPOFt flows growth with aa IG relative to 56% Data în panel (b) show that U.S. spe 08 È imich more likely to satisfy the U.S./EZ GDP, 60 and EU stocks are comparably growth, 0.7 OCA criteria than the EU is. Why? total RITO average 0.6) Data in panel (4) show that cs |A 051 interrezional trade in the United 40 States ses to levels much higher ce than those seen among EU 03 countries 20 i di ci 0 Sl U.S. regions _ 54 ccuntries U.S. states EZ countries (6). or dn (50) an states 5 states* (50) Labor Mobility * Labor in Europe is much less mobile between states than it is in the United States. The flow of people between regions is also larger in the United States than in the EU. * Labor markets in Europe are less flexible, and differences in unemployment across EU regions tend to be larger and more persistent than across the United States. * The labor market adjustment mechanism is weaker in Europe. On this test, Europe is far behind the United States. Fiscal Transfers * Stabilizing transfers, whereby substantial taxing and spending authority are given to the central authority, exist in the United States but not in the EU. Summary * On the OCA criteria, the EU falls short of the United States as a successful optimum currency area, as shown in Figure 10-5. * Goods market integration is weaker, fiscal transfers are negligible, and labor mobility is low. At best, economic shocks in the EU are fairly FIGURE 104 (3014) — (NI (€) Labor Mobility Criterion [FIGURE 104 (4 ta, (d) Fiscal Criterion OCA Criteria for the Eurozone Persona born 50% OCA Criteria for the Eurozone and Share of dn ar he United Stnes contimed) VR n the United States (continued) local ia 286 Data in panel () show ther U.S. “Pte/en ne 40 Data in panel (d) show that sino nei labor markets are very integrated vini interstate fiscol stabilizers are large oe compared with those of the EU. “n in the United States, but essentially nonevistent in the EZ. 1 U.S. states” EZ couniries states EL countries so) n) (50, range (17) ol estimates) symmetric, but this gives only limited support for a currency union given the other shortcomings. * Most economists think there are still costs involved when a country sacrifices monetary autonomy. * On balance, economists tend to believe that the EU, and the current Eurozone within it, were not an optimum currency area in the 1990s and that nothing much has happened yet to alter that judgment. Are the OCA Criteria Self-Fulfilling? * Some economists argue that by adopting a common currency, it might become an OCA in the future. * Joining a currency union might promote more trade, by lowering ; SAVE TAR transaction costs. _ . . and EU countis do not satify the OCA criteria _ hey havs too lite market itegraton and hci « If the OCA criteria were applied ex ante (before the currency union forms), Sockeare im agmmette The Firnzone muy becero e OCA in since inegrt'on rune Lech her, bus sl ‘ar Bekind he Unica State a the OCA criteri. I e expand 0 the EU 0127 ts cy ha hs leer zone fs to met OCA citi by an cen lager mangio, wtti BEE Symmetry-Integration Diagram Symmetry of shocks| However, policy makers failed to spot key macroeconomic and financial developments that were to plunge the Eurozone into crisis in 2008 and beyond. Boom and Bust: Causes and Consequences of an Asymmetrical Crisis * The devotion to inflation targeting of the ECB came at the cost of insufficient attention to financial stability. * In Greece, much of the borrowing was by a fiscally irresponsible government that was later found to be falsifying its accounts. * In the other nations the flow of loans fieled a residential construction boom that in places (e.g., Dublin and Barcelona) rivaled the property bubble in parts of the United States. * When growth slowed sharply much of the construction and overconsumption in the peripheral economies tumed out to be unjustified and unsustainable. The Policymaking Context The Eurozone faced hard choices after the crisis hit in 2008, but the policy measures taken were more timid and quickly reversed. The choices made can potentially be explained by considering the unique features of the European monetary union. * Limited Lender of Last Resort The Eurozone is a monetary union, but the ECB is inflation averse, it's restricted from direct government finance, and cannot act as the lender of last resort. * No Fiscal Union The Eurozone lacks a political-fiscal union, and has no fiscal policy tools, because there is no central budget that can be used to engage in cross-country stabilization of shocks. This is in large part due to the absence of a central European government (executive power) standing above the sovereigns (the member states). * No Banking Union The Eurozone also lacks even the minimal political-fiscal cooperation to create a banking union, meaning that responsibility for supervising banks, and resolving or rescuing them when they are insolvent, rests with national sovereigns. * Sovereign-Bank Doom Loop Eurozone country’s national banks tend to hold local sovereign’s debt; but, in tum, these sovereigns can end up bearing large fiscal costs to repair banking systems and protect depositors from losing their money. The banks and the sovereign can then enter into a socalled “doom loop.” * Labor Immobility Because the Eurozone is especially weak on labor mobility (one of the OCA criteria), a local economic slump (say, in Spain) is likely to persist for longer because unemployed workers cannot migrate easily to another country where there are better opportunities. * Exit Risk Events have shown that the risk of a country’s exit can put financial pressure on that country. If investors suspect that a country will exit the Eurozone, they will want to pull their money out of the countrys banks and sell its debt to avoid potential losses. Timeline of Events * In April 2010 Greece requested help as its country risk premium spiked and it could no longer borrow at sustainable rates. * The EU/ECB/IMF jointly devised a plan to provide €110 billion of loans that would give Greece two to three years of guaranteed funding. However turmoil continued and further measures were announce in May 2010. * To help other troubled nations (Ireland, Spain, Portugal, and Italy were all at risk), all EU countries established a fund to provide loans of up to €440 billion, now known as the European Stability Mechanism (ESM). * A further sum of €250 billion was pledged by the IMF, in addition to a €60 billion credit line provided by the EU. * Authorities thought these funds would be large enough to cope with financing problems that might arise in Ireland and Portugal. * If financing problems had occurred in larger countries like Spain (or, even worse, Italy), they would have had to come up with more resources. * The announcement of these measures kept the panic under control only for a time. * The risk premiums of the peripherals spiked again in November 2010, after EU leaders said they wanted to possibly impose losses on bondholders in any future rescues. * Greece”s debt was so large that it eventually had to impose a partial default in February 2012. * Greece remained in the Eurozone, but by 2013 the Greek unemployment rate was 27%, among youths 58%. * Economies elsewhere in the periphery also reluctantly entered into bailout programs as conditions deteriorated. * In Ireland, after adopting harsh austerity, unemployment rose from 4% in 2006 to 15% by 2012, and among youths it rose to 30%. Ireland was not able to borrow affordably in financial markets again until July 2012. * Portugal and Spain accepted bailouts in 2011 and 2012. By 2013 Spanish unemployment reached 27%, and 56% among youths; in Portugal the rates reached 11%, and 38%, respectively. * Rather than allowing the peripherals to default the EU decided on a “moral hazard” or “bailout” approach of trying to ensure that no bank or govemment creditors were ever hurt. * These decisions cast aside the prior notion that every Eurozone country was responsible unto itself and the idea that the ECB would not go along in any bailouts. * In 2012 the ECB promised to do “whatever it takes” to save the euro, but it isn’t clear what that meant, and the exact scope and terms of a proposed ECB bond-buying program are still unknown. * But some fear that undertaking such programs will lead to fiscal dominance, money printing, and inflationary budget financing. * To the skeptical, the Eurozone/ECB approach has been a giant “extend and pretend” refinancing scheme to postpone tough choices at the nexus of monetary, fiscal, and banking policies. * Given the dismal growth path that is expected to continue into the future, the approach will likely fail unless it makes a plan to write down or restructure the underlying losses of banks and governments in the periphery, and even some in the core. * From 2010 to 2013 the governments of the Eurozone tumed very hard in the direction of fiscal austerity. Not coincidentally, in late 2011 the Eurozone went into a double-dip recession. * Because peripherals have no currencies to depreciate, the only way they can restore competitiveness and output is by a large decline in ‘wages and costs, a tough process that is rarely successful. * If the efforts to keep the Eurozone intact fail, and if political will evaporates, one or more peripheral countries may default, and even exit the Eurozone. * In that event, huge economic sacrifices and deep social damage will have been imposed on their populations, seemingly for nothing. Conclusions: Assessing the Euro The OCA criteria can be used to examine the logic of currency unions and Europe does not appear to satisfy the narrow definition. How well can the euro hold up in the future? Even after the crisis, both optimistic and pessimistic views persist. Euro-optimists * For true optimists, the euro is already something of a success: it has functioned in a perfectly adequate way and can be expected to become only more successful as time goes by. * More countries are lining up to join the Eurozone. Even if there are costs in the short run, the argument goes, in the long run the benefits will become clear * The euro will create more trade in the Eurozone. It may also create more labor and capital mobility. * Cross-border asset trade and FDI flows in the Eurozone also have increased. * The ECB will prove to be a strong, credible, independent central bank. * The euro is increasingly becoming a reserve currency for foreign central banks, and is now the dominant currency used in international bond markets. * The optimists believe that the adoption of the euro, like entry to the EU itself, means “no going back”: there is simply no imaginable political future for Europe apart from union. Euro-pessimists * For true pessimists, the preceding arguments are not convincing. * The impact of the euro on (already high) intra-EU trade levels will be small. * Cultural and linguistic barriers will persist, labor migration will be limited and held back by inflexible labor market institutions in most countries. Regulatory and other frictions will remain. * If integration stops for lack of political support, a key economic rationale for the euro unravels. * There is wide divergence in the countries of the Eurozone with respect to monetary policy. * When the ECB was put to the test after the 2008 crisis, the ECB caved in and continued to lend against peripheral country government debt of declining quality. * In 2012 the ECB said it would do “whatever it takes” to save the euro, launching the Outright Monetary Transaction bondbuying program, ‘which has yet to be deployed. * At best, even if the euro survives, pessimists believe the region will suffer slow growth and ongoing internal conflicts. * At worst, the tensions could be so great as to cause the breakup of the Eurozone into blocs or the reintroduction of the former national currencies. Summary * The Eurozone may be a workable albeit economically costly currency union. * On the downside, EU enlargement undercuts the OCA logic in the short run and could make the ECB’s governance more difficult. There is a risk of a clash between the fiscal goals ofthe governments and monetary goals of the ECB. * The results of successive Eurobarometer polls indicate that only about 50% to 60% of the citizens of the Eurozone think that the euro has been beneficial. * The euro remains an experiment—its arrival did not mark the end point of European monetary history, and its long-run fate is not entirely certain. Lecture 12: The European Central Bank The ESCB includes the ECB and the 27 National Central Banks. General council: President, Vice-President plus Governors of all EU national central banks. Quarterly meetings. Reports on convergence. The Eurosystem is formed by the ECB and the (currently) 19 Euro area NCBs. * Governing Council: supreme decision-making body, composed by 6 member of the Executive Board and 15 euro area govemors. Meetings in Frankfiut twice a month. Formulates monetary policy. Acts by single majority: one head, one vote. 6 executive members have permanent voting right. Governors rotate once their number exceeds 15. Rotation in the Goveming Council * Executive Board: President, Vice-President + 4 members appointed by Heads of State or Governments of euro area countries. Implements monetary policy of ECB. Prepares meetings of GC. Conducts day-by-day business ofthe ECB. — the primary objective ofthe ESCB shall be to maintain price stability Objective: price stability defined as year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area below, but close to 2%. Without prejudice to price stability, the ESCB shall support the general economic policies in the Union...that may include full employment and sustainable and non-inflationary growth. >Medium run price stability. German model vs. anglo-french model. The ECB”s approach to organising and evaluating the information relevant for assessing the risks to price stability is based on "two pillars”: economic analysis and monetary analysis. * The economic analysis assesses the short to medium-term determinants of price developments: GDP, demand and labor market conditions, a broad range of price and cost indicators, fiscal policy, exchange rate and the balance of payments for the euro area, etc... * The monetary analysis focuses on the long-run link between money and prices. Annual growth of the broad aggregate M3 (< 4.5% per year, target value). Am = Ap + Ay — Av PRIMARY OBJECTIVE OF PRICE STABILITY The transmission mechanism of monetary policy Process through which monetary policy decisions affect the economy in general, and the = Governing Council price level in particular. takes monetary policy decisions based on an overall assessment Monetary policy usually takes a considerable time to affect price developments. af the risks to price stability Long, variable and uncertain lags in the conduct of monetary policy. . ECONOMIC MoneTRY Empirical studies: an decrease in short-term interest rates results in a temporary increase in ANAWSIS ANALYSIS output, which peaks about two years after the initial impulse. Prices adjust gradually to a Analysis cross-checking Analysis permanently higher level. of ne of monetary trends Monetary policy instruments Open market operations (usually with one week or one month maturity). FULL SET OF INFORMATION Standing facilities. —— Shocks outside Minimun reserve system Sen Ben Open market operations l Main refinancing operations: Key monetary policy instrument through which [1 Pectations METESIDARE Changes in the Eurosystem lends funds to its counterparties. T 1 risk premia * Central bank buys assets under a repurchase agreement or grants a [ [Changes in loan against assets given as collateral. In the repurchase agreement rm n SS res] bank capital case, the difference between the purchase price and the repurchase { credit - prices H rates H rate I, [Changes in the price corresponds to the interest rate due on the amount of money ——__——_ global economy borrowed. L_.{ Wage and Supply and demand in i_[Changes in Standing facilities price-setting goods and labour markets fiscal policy Overnight maturity: facility for daily management of liquidity. Available to Tomi impori i | Changes in counterparties on their own initiative. T_71.__ptices | prices commodity * Marginal lending facility: ceiling for the ovemight rate in the money rea — market EONIA (normally + 1% of main refinancing rate). * Deposit facility: floor for the ovemight rate in the money market (normally - 1% of mir).