1.3 different ER regimes: from free floats to monetary unions

Question 1

what are the two major disadvantages of fixed ERs

Answer 1

MP unavailable for countercyclical macroec. policy,

nominal ER no longer a “real-shocks absorber”

Question 2

difference between speculative attack and devaluation under flexible

Answer 2

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

Question 3

what is competitive devaluation and what can it cause

Answer 3

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

Question 4

what is the equation that shows why Greek and Italian yields are higher than German

Answer 4

under fixed, it=i*t+ρ,

ρ higher for these countries

Question 5

under flexible what does a positive ε shock do

Answer 5

upward pressure on it,
downward pressure on st,
on AA-DD diagram, pressure for AA to shift leftward/downward

Question 6

under fixed what does a positive ε shock do

Answer 6

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)

Question 7

why does fixed ER make sense for Argentina

Answer 7

lack of confidence in domestic monetary institutions,

inflation 3,000% 1989

Question 8

example of country that has benefited from a weak currency

Answer 8

China have allowed the currency to depreciate substantially in real terms, this has made the country more competitive and has facilitated growth

Question 9

under fixed how do they do a devaluation

Answer 9

CB do this by simply announcing that it is willing to buy and sell FOREX reserves against domestic currency at a new higher value

Question 10

pros of flexible

Answer 10

independent monetary policy,
nominal ER can act as a real-shocks absorber,
currency crises less likely

Question 11

negative of flexible

Answer 11

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)

Question 12

what is the theory of optimum currency areas

Answer 12

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

Question 13

what does economic integration mean

Answer 13

free flows of:
goods and services (trade),
financial capital (assets) and physical capital,
workers/labour

Question 14

when is joining a fixed ER system beneficial for a country

Answer 14

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

Question 15

what else does high economic integration allow

Answer 15

prices to converge btw. members of a fixed ER system and a potential member

Question 16

what happens if after joining a fixed exchange rate system, the new member faces a fall in aggregate demand (at)

Answer 16

relative prices tend to fall (pt down as long as yt

Question 17

what is it that drives competitiveness

Answer 17

real exchange rate qt=st+pt*-pt

Question 18

what are other considerations of optimum currency areas

Answer 18

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

Question 19

why do business cycles become synchronised for OCA

Answer 19

when one region does badly they no longer demand as much from other regions: normally one policy should be appropriate for all areas

Question 20

when was euro introduced

Answer 20

1999

Question 21

when was the euro crisis

Answer 21

2010/12

Question 22

what are the gips countries

Answer 22

greece, ireland, portugal and spain

Question 23

what caused inflation in eurozone

Answer 23

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)

Question 24

how were eurozone countries like greece and ireland able to have large negative CAs from 2005-09

Answer 24

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)

Question 25

talk about the euro on the single market

Answer 25

reasonably high intra-EU trade but still lower than across regions in a given country,

Question 26

talk about the euro on labour mobility

Answer 26

labour mobility low although has improved in recent years, differences of US unemployment across regions smaller and less persistent

Question 27

talk about the euro on the similarity of economic structures and business cycles

Answer 27

north and south specialise in different G&S but some business cycle synchronisation

Question 28

talk about the euro on fiscal federalism

Answer 28

EU budget extremely small, net contributors pay about 0.5% of GDP to Brussels,
tiny compared to national budgets

Question 29

is the EU an OCA

Answer 29

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

Question 30

talk about the future of the euro

Answer 30

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

Question 31

what is a currency board

Answer 31

exchange rate system in which ER fixed to an anchor currency and CB’s monetary base entirely backed by FOREX reserves

Question 32

what is the CB balance sheet under a currency board

Answer 32

ht+nwt=rt,

cannot buy domestic credit (even in secondary markets)

Question 33

what is the key consequence of a currency board arrangement (CBA)

Answer 33

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

Question 34

what are some examples of CBAs (currency board arrangements)

Answer 34

Argentina (1991-2002)

Bosnia and Bulgaria (97-present)

Question 35

under a currency board what happens if there is ED for domestic currency

Answer 35

capital flows in, rt up and ht up (mt up) automatically

Question 36

pros of a currency board arrangement

Answer 36

std. advantages of fixed rates

+ stronger commitment device: very often enshrined in law and in CB’s charter to sort a high-inflation episode

Question 37

cons of a currency board arrangement

Answer 37

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)

Question 38

what is china ER system

Answer 38

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

Question 39

what was the cause of the EZ crisis from Baldwin et al (2015)

Answer 39

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

Question 40

why did EZ membership make the EZ crisis worse (Baldwin et al 2015)

Answer 40

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