Macroeconomics (& Finance) Flashcards
OCA
Optimum Currency Area is a geographical area where the efficiency gain of joining a fixed exchange rate system is at least as large as the economic stability loss.
The efficiency gain of joining a fixed exchange rate system depends on the amount of economic market integration.
Economic intergration means free flows of:
1) Goods and services (more trade, means reduction of transaction costs)
2) Financial capital and physical capital (free flow of capital means less uncertainty about rates of return)
3) Workers/labor (free flow of workers means the uncertainty about wages would be greatly reduced)
Explain what fiscal integration is and why it is needed for a currency union to be an OCA.
An OCA needs either very integrated regions or regions frequently hit by symmetric
shocks. If countries are hit by asymmetric shocks, the currency union needs fiscal
integration – a large federal component to spending at the regional or local level – to help
in dealing with asymmetric shocks.
Exchange rate crisis
When a currency experiences a sudden and pronounced loss of value against another currency following a period in which the exchange rate had been fixed or stable. (=> often linked to governments declaring default on bond payments)
Why are exchange rates so important:
Impact through relative prices of:
-Goods
-Services
-Assets
-Labor
Impact on wealth:
-Impact on allocation
-Trade of goods and services
-Capital flows
-Labor mobility
Fixed exchange rate
an exchange rate in which the currency fluctuates in a narrow range against some base currency over a sustained period
Floating exchange rate
an exchange rate in which the e.r. fluctuates in a wider.
Spot contract
Simple forex transaction for the immediate exchange of two currencies. (=> most commonly used)
Forward contract
The contract is made today, but the settlement date for the delivery of the currencies is in the future.
The Law of One Price
Under certain conditions, identical goods sold in different locations must sell for the same price when expressed in a common currency.
P us = E$/€ * P us
(for a good)
Purchasing Power Parity
Same as the LOOP, but then for a basket of goods.
P us = E$/€ * P us
CIP
Covered Interest Parity (return on domestic deposit should be equal to the return on foreign deposit in domestic currency):
F = E$/€*(1+ i$/1+i€)
UIP
Uncovered Interest Parity:
E^e$/€ = E$/€*(1+i$/1+i€)
Long run neutrality of money
In the long run changes in nominal variables (e.g. money supply or nominal interest rate) have no effect on real variables such as employment, output, or productivity.
(=> increase in Ms: increases the amount of currency in circulation and lower interest rates
=> Lower i stimulates companies to invest, which leads to more people’s spending and thus more production, and thus higher wages and income in the short run.
=> Eventually inflation will equalize these effects. (In the long run, production is determined by the ability to improve technology and by factors of production)
Monetary Policy (fixed and floating)
(short-run effect)
Fixed exchange rates: monetary policy has no effect!
Floating exchange rates: has short-run effects
Trilemma (impossible trinity)
A country can choose two of the three policy goals:
1) free capital flows (UIP holds)
2) fixed exchange rate
3) independent monetary policy (home interest rate is possibly different than the international interest rate)
Fiscal Policy (fixed and floating)
Fixed exchange rates: More powerful under fixed e.r. regime
Floating exchange rates: has short-run effects.
Black Wednesday (September 16, 1992)
Event: The British pound was forced to exit the European Exchange Rate Mechanism (ERM) due to speculative attacks.
Key Figure: George Soros, who profited over $1 billion by betting against the pound.
Why It Happened:
The ERM pegged European currencies to the Deutschmark. The UK economy was in recession, and the pound was overvalued.
The UK couldn’t lower interest rates to stimulate its economy without violating ERM rules (interest rate parity condition).
What Happened:
Speculators believed the pound would devalue, so they sold it in exchange for other currencies.
The Bank of England raised interest rates and used foreign reserves to buy pounds to defend the currency peg.
Ultimately, the UK couldn’t maintain the peg and let the pound float freely, causing a sharp depreciation.
Consequences:
The pound devalued, but this led to economic recovery as lower interest rates boosted growth.
Key Lesson: Fixed exchange rates can be vulnerable to speculative attacks if a currency is overvalued or the economy is weak.
Why might Floating Exchange rates be less optimal?
- Low effectiveness of Fiscal Policy
- The exchange rate is likely to fluctuate a lot and be difficult to control with Monetary Policy.
Eventough flexible exchange rates seem preferable, why did the European countries decide to create the Euro and have a fixed e.r. between them?
- High integration
- When domestic central banks have problems commiting to a policy rule, it is usefull to give up monetary policy independence.
Plan to create the Economic and Monetary Union (EMU) of the EU?
Stage 1:Abolish all exchange rate controls and free capital mobility between all countries of the European Economic Community.
Stage 2: Stability and growth pact => ECB is created and countries agree on the criteria signed in the Maastricht Treaty
Stage 3: Euro is created
What is an asymmetric shock?
Negative event affecting a specific geographical area.
Three benefits of joining a currency area
1) Avoiding uncertainty, international transaction costs, and currency risk of floating exchange rates
2) Higher price transparency => more competition!
3) Time inconsistency of MP
(Joining the Eurozone helps countries with a history of high inflation gain more trust in their economic policies by giving control of inflation to a central authority (the European Central Bank), which ensures prices stay stable and prevents them from making short-term decisions that would lead to more inflation.)
The main two costs of joining a currency area
1) Loss of Monetary Policy Independence
2) Loss of Exchange rate policy
Two ways to move to the previous equilibrium if a country is hit by an asymmetric shock (not using monetary or fiscal policy)
- Wage flexibility (=> Decreasing domestic prices by reducing wages)
- Labor mobility
