Lecture 4 & 5 Flashcards
What is the Triffin Dilemma?
Increased stock of $ outside the US => US gold reserves are inadequate. Since dollar is no longer backed by gold, it was not a credible system. Lead to Bretton Woods collapse.
What is the ERM?
European Exchange Rate Mechanism was a system introduced in 1979 in the EU. “Fixed” exchange rate system where the currencies were locked together, with allowed fluctuations of 2,25%. Was not able to prevent a trend in FF/DM, where FF devalued by 49,1% from 1979 to 1992. Danish “No” (to the Maastrict-treaty) in 1992 lead to uncertainty about the future of the system -> it collapsed.
What is the 3rd phase of EMU?
From 1.1.99 the Euro is now a real currency with 11 countries meeting the criterias of the system (except the debt-target of 60%). One year later the coins and notes starts circulating.
What is a Currency Board?
A system for small economies, where domestic currency is backed with foreign currency (ideally 1:1). Good at getting inflation under control and creating financial stability. However, it is rather inflexible.
What is Dollarization?
A system for small economies, where you replace your currency (money supply) with USD (or another major currency). Main purpose is to create financial stability.
What is the components of the Impossible trinity?
1: Exchange rate stability (fixed exchange rate). 2: Full financial integration (perfect capital mobility). 3: Monetary independence (set your own interest rate). You can’t have all three.
Example of the impossible trinity. Fixed exchange rate and perfect capital mobility.
In this case i=i*. Suppose the central bank reduces i (when the CB wants to pursue an independent monetary policy). Outflow of capital (sell domestic currency and purchase foreign currency). Eventually, the currency will have to be devalued.
Explain R (real exchange rate).
Nominal exchange rate S = foreign currency per 1$ (eg. 115 Yen/$). S up: $ appreciates. Real exchange rate R = P usaS/P. R=US prices in foreign currency/foreign prices. R up: real value of the $ appreciates; the US is losing competitiveness. R is a measure of competitiveness.
Explain the Euro crisis with the real exchange rate.
Consider R for Greece relative to Germany: R = PGreece * S / PGermany. S is in this case equal to 1 (since both Greece and Germany use the Euro). Hence R is: R=PGreece /PGermany. R has been increasing for a long time since Greece has higher inflation than Germany due to lower productivity growth. The fundamental problem is that Greece is losing competitiveness.
Explain a way to solve the Euro crisis (PIIGS losing competitiveness).
Reintroduce S (local currency). S would likely drop by 50% and it would be much cheaper for foreigners to buy Greek goods and services. R will decline by 50% over night. The risk is that Greece will get inflation (sharp increase in PGreece. Also, the Euro denominated debt will sharply increase.
What is the Balance of Payments (BoP)?
Records all transactions a country has with the rest of the world. Current account transactions: Export and import of goods and services plus income and transfers. Financial & capital account transactions: Purchases of foreign assets (foreign firms, stocks, bonds, real estate, deposits in foreign banks) & sales of domestic assets. If BoP is positive: inflow of money; if negative: outflow.
How does the US finance its large current account deficit (more import than export)?
By increasing its financial account through sales of domestic assets (bonds and securities). I.e. the US is getting loans from other countries.
How does the Central Bank finance a BoP deficit in a fixed exchange rate regime?
By selling (supplying) foreign currency to the FOREX market and thus buying domestic currency.
What happens if the Central Bank has run out of reserves to finance a BoP deficit in a fixed exchange rate regime?
Then the country is in deep trouble (recently almost happened in the US, though that was because of politics). The country may try to borrow funds abroad, often from the IMF. The IMF will then tell the country to depreciate its currency, and reduce fiscal spending or increase taxes.
What happens with a BoP deficit in a country with freely floating exchange rates?
If there is a deficit on the BoP say due to a current account deficit, the exchange rate or something else adjusts until BoP is 0 (typically through changes in X and Z). Occasionally, CBs intervene in the market in order to stabilize “e” (“dirty floating”).
