T8 Optimum currency areas.The Economic and Monetary Union(Chapter 14) Flashcards
Two important principles
The interest rate parity condition and purchasing power parity
only one thing is traded on market for goods and services and fin ancial market
the good with price P and the bond with with ir
the main aim is to
determain how their work independently and interact
partial equilibrium
separated equalibrium of both markets
general equilibrium
equilibrium of both markets simultaneously
in macroeconomic the good
is the country GDP
y=
Y=C+I+G
Why when the interest rate is higher firms invest less?
because they borrow less
there is a negative effect of equilibrium (caused by increased of ir)
of the interest on equilibrium GDP
Why economy is always at its IS curve?
A trader deciding on investing anywhere in the world
Compares interest rates;
- Considers exchange rate fluctuations: if foreign currency
appreciates, an investment abroad will also lead to capital gain.
Does the interest rate parity condition work?
Interest parity condition interpreted as revealing market expectations:
Expected exchange change rate depreciation = Domestic interest rate
- Foreign interest rate
.
But on top of exchange rate fluctuations there is also risk:
Interest rate of risky asset = Interest rate of safe asset + Risk premium
Three principles (2): purchasing power parity
Flexible exchange rate:
Currencies continuously priced by (foreign)
exchange markets
Fixed exchange rate:
Government keeps exchange rate fixed through
reserves and buying and selling currency
Assuming free movement of capital
monetary policy is deeply
affected by exchange rate regime
The impossible trinity principle is central to European integration:
fixing the exchange rate means adopting the foreign interest
rate; conversely, maintaining the ability to choose the domestic
interest rate requires allowing the exchange rate to float freely.
One way of escaping the choice between exchange rate stability and
monetary policy autonomy is to restrict capital movements.
Many European countries operated extensive capital controls
until the early 1990s
– Many of the new EU members only abandoned capital controls
upon accession.
Since the EU adopted in 1992 the principle of open capital
markets,
the choice has been circumscribed to the left or
bottom sides of the triangle.
There are examples for each side of the impossibility triangle:
- Full capital mobility and autonomous monetary policy: Eurozone as
a whole, USA, Japan, UK, Switzerland, Sweden:
* Any advantages? And disadvantages? Look at the British and Swiss
cases:
graph
Full capital mobility and fixed exchange rates: EU Exchange Rate
Mechanism; Denmark
why
graph,to reduce risk !
The Danish CB shadows the ECB interest rates:
Fixed exchange rate and monetary policy autonomy:
many
developing and emerging countries, which establish capital controls
(e.g. see trends of Brazil, China, and Switzerland against the dollar
during the crisis).
What happens when one tries to violate the impossible trinity?
A
currency crisis: sooner or later a speculative attack wipes out
the fixed exchange rate arrangement
our currency goes up when
inflation abroad is higher than at home
