1.3 different ER regimes: from free floats to monetary unions Flashcards
what are the two major disadvantages of fixed ERs
MP unavailable for countercyclical macroec. policy,
nominal ER no longer a “real-shocks absorber”
difference between speculative attack and devaluation under flexible
runs on currency happen for both,
not as likely under flexible and typically not as big,
once currency under pressure to lose value will lose value now,
however under fixed and gov. committed could be under pressure for years and then sharp drop when it does
what is competitive devaluation and what can it cause
when say Argentina devalues currency relative to Brazil (biggest trading partner),
can cause tension between trading partners,
Brazil may then retaliate by say increasing their money supply
what is the equation that shows why Greek and Italian yields are higher than German
under fixed, it=i*t+ρ,
ρ higher for these countries
under flexible what does a positive ε shock do
upward pressure on it,
downward pressure on st,
on AA-DD diagram, pressure for AA to shift leftward/downward
under fixed what does a positive ε shock do
cannot be absorbed by upward pressure on it,
CB must absorb shock with an automatic increase in mt and shifts AA rightward/upward (output unchanged) (in diagram the curve hasn’t actually shifted just weird arrow 6/44 1.3)
why does fixed ER make sense for Argentina
lack of confidence in domestic monetary institutions,
inflation 3,000% 1989
example of country that has benefited from a weak currency
China have allowed the currency to depreciate substantially in real terms, this has made the country more competitive and has facilitated growth
under fixed how do they do a devaluation
CB do this by simply announcing that it is willing to buy and sell FOREX reserves against domestic currency at a new higher value
pros of flexible
independent monetary policy,
nominal ER can act as a real-shocks absorber,
currency crises less likely
negative of flexible
ER variability act as barrier to trade and investment flows,
nominal ER can be a source of shocks to real ER,
regime not perfectly insulate economy from negative effects of a “currency crash” (dollar denominated debt)
what is the theory of optimum currency areas
the theory of OCAs argues that the optimal area for a system of fixed exchange rates, or a common currency, is one that is highly economically integrated
what does economic integration mean
free flows of:
goods and services (trade),
financial capital (assets) and physical capital,
workers/labour
when is joining a fixed ER system beneficial for a country
if`:
trade is extensive between it and member countries,
financial assets flow freely between it and member countries,
people migrate freely between it and member countries
what else does high economic integration allow
prices to converge btw. members of a fixed ER system and a potential member
what happens if after joining a fixed exchange rate system, the new member faces a fall in aggregate demand (at)
relative prices tend to fall (pt down as long as yt
what is it that drives competitiveness
real exchange rate qt=st+pt*-pt
what are other considerations of optimum currency areas
degree to which countries have similar economic structures,
degree of business cycle synchronisation,
extent to which there are supra-national fiscal tax-transfers: fiscal freedom
why do business cycles become synchronised for OCA
when one region does badly they no longer demand as much from other regions: normally one policy should be appropriate for all areas
when was euro introduced
1999
when was the euro crisis
2010/12
what are the gips countries
greece, ireland, portugal and spain
what caused inflation in eurozone
ability to borrow cheaply due to no spread between german and their yield,
unless invested heavily and productive potential increased then economy producing yt>ybar so will eventually lead to inflation (spent on consumption not increasing productive potential)
how were eurozone countries like greece and ireland able to have large negative CAs from 2005-09
as long as CA+KA=0,
has to be running large capital account surplus,
German commercial banks were sending a lot of money to GIPS economies (core to periphery)
talk about the euro on the single market
reasonably high intra-EU trade but still lower than across regions in a given country,
talk about the euro on labour mobility
labour mobility low although has improved in recent years, differences of US unemployment across regions smaller and less persistent
talk about the euro on the similarity of economic structures and business cycles
north and south specialise in different G&S but some business cycle synchronisation
talk about the euro on fiscal federalism
EU budget extremely small, net contributors pay about 0.5% of GDP to Brussels,
tiny compared to national budgets
is the EU an OCA
clearly not but, with hindsight:
national fiscal policy should have been available,
labour costs should have risen much more slowly in many countries relative to Germany’’s,
adjustments through internal devaluation very slow,
should have thought of crisis management and resolution mechanisms
talk about the future of the euro
ECB must be lender of last resort,
single supervisory mechanism: now ECB’s responsibility,
single resolution mechanism,
more fiscal union essential:
more surveillance and enforcement of fiscal discipline
what is a currency board
exchange rate system in which ER fixed to an anchor currency and CB’s monetary base entirely backed by FOREX reserves
what is the CB balance sheet under a currency board
ht+nwt=rt,
cannot buy domestic credit (even in secondary markets)
what is the key consequence of a currency board arrangement (CBA)
can no longer increase ht (hence mt) by buying gov. bonds in secondary bond markets,
increases and decreases money supply only as result of interventions in FOREX market
what are some examples of CBAs (currency board arrangements)
Argentina (1991-2002)
Bosnia and Bulgaria (97-present)
under a currency board what happens if there is ED for domestic currency
capital flows in, rt up and ht up (mt up) automatically
pros of a currency board arrangement
std. advantages of fixed rates
+ stronger commitment device: very often enshrined in law and in CB’s charter to sort a high-inflation episode
cons of a currency board arrangement
std. advantages of fixed rates
+ bec. often seen as more credible than simple fixed ER, may stimulate larger currency mismatches (commercial banks see less need to hedge potentially creating a much bigger collapse in assets due to mismatch)
+ limits ability of CB to operate as lender of last resort (eg loans to troubled domestic banks)
what is china ER system
managed float at a competitive level; while monetary policy still independent,
gov. able and willing to use strong capital controls,
costs:
trade tensions, including with US,
financial markets not fully developed,
low yielding FOREX reserves
what was the cause of the EZ crisis from Baldwin et al (2015)
big capital flows from EZ core (Germany, France) to periphery (Ireland, Portugal and Greece) spent on consumption and housing so didn’t increase productive potential of economy
why did EZ membership make the EZ crisis worse (Baldwin et al 2015)
crisis amplifier,
EZ governments that got into trouble had no lender of last resort bc national CBs couldn’t create money to lend and the ECB was explicitly forbidden from doing so.
The other crisis response - devaluation - was also not possible.
Contagion
