Chapter 3: International Currency System: Flexible and Fixed Exchange Rates

Question 1

How does independence of monetary policy differ depending on the choice of floating/ fixed exchange rate system?

Answer 1

Fixed exchange rates: Central banks are dependent and have to intervene, can’t be independent

Question 2

Fixed exchange rates: Can central banks in the long run succeed in compensating foreign exchange markets monetary effects through sterilised interventions?

Answer 2

• Sterilised interventions not possible in the long run
• Country averts stabilising effects of monetary mechanisms
• lose official reserves

Question 3

Why are fixed exchange rates, independent monetary policy and free capital mobility incompatible in the long run?

Answer 3

• Incompatible trinity
• If country wants to have different policy than base country but also keep the other factors: Sell foreign currency -> in the long run they will run out of reserves

Question 4

Preconditions of fixed exchange rate systems

Answer 4

• Economic integration
• Economic stability
• Harmonisation of monetary policy

Question 5

Fixed exchange rate system vs. single currency area

Answer 5

• single currency area much stricter
• doesn’t allow revaluations and devaluations
• no exit option

Question 6

Maastricht really conditions for Euro-area entry

Answer 6

3 monetary rules:
-interest rates shouldn’t deviate
-inflation rate should be close to others
-exchange rate shouldn’t fluctuate too much against Euro
2 fiscal rules:
-fiscal deficit not over 2%
-total debt not over 60%
-> important also after entry because countries with high nominal debt will lobby for high inflation once in union

Question 7

Why did the Maastricht criteria fail?

Answer 7

• rules not complied with
• no punishments
• Germany used its power to negotiate fine away
• if Germany as largest economy isn’t sectioned, others have no reason to comply with rules

Question 8

Conditions required for members to benefit from optimal currency areas

Answer 8

Conditions: Economic integration, economic similarity, harmonisation of monetary policy
Benefits: Efficiency benefits, lower stability costs, stability gains, political benefits

Question 9

How well does Euro-area fit with optimal currency area theory’s requirements?

Answer 9

• Integration criterion: low interregional trade
• Symmetry criterion: average symmetry
• Labor mobility criterion: low, labor markets not that integrated due to language differences
• Fiscal criterion: interstate stabilisers essentially nonexistent