the fragility of incomplete monetary unions Flashcards
what is a complete monetary union?
a monetary union together with a budgetary union
what is an incomplete monetary union?
a monetary union where each member country maintains its own independent budgetary policy
when did the bretton woods system collapse?
it collapsed in 1971
why did monetary intergration lose momentum in the mid 1970s?
it lost momentum due to stagflation and instability in the international markets
what are the two reasons for the fragility of the fixed exchange rate system?
credibility problem and a liquidity problem
what is the credibility problem of fixed exchange rates?
when the authorities announce a fixed exchange rate, they are making a promise to keep the exchange rate fixed today and in the future. circumstances may arise in which the fixed exchange rate ceases to be seen as serving a nations best interest. in that case the monetary authority will have an incentive to renege on its promise. economic agents will suspect this and will attack the economy. a speculative crisis arises
what is the liquidity proble, of the fixed exchange rate system?
countries on a fixed exchange rate have a limited stock of international reserves to defend the fixed exchange rate. the promise to convert domestic currency into foreign currency at the fixed exchange rate cannot be guaranteed because the central bank has insufficient foreign exchange. as investors know this, they will become nervous when they see that the stock of international reserves being depleted.
what are the interactions between credibility and liquidity problem?
the limtied stock of international reserves reduces the credibility
low credibility leads speculators to sell the domestic currency
forcing the central bank to sell foreign exchange thereby reducing the stock of international reserves and so a devaluation occurs
why is the eurozone a type of incomplete monetary union?
it is incomplete because it is a monetary union without a budgetary union. there is one monetary authority the ECB and many independent national authorities in the euro area. the national governments issue debt in the common currency they don’t have control over,
what are the benefits of defaulting on debt?
government reduces interest burden on outstanding debt.
less austerity will be applied
the initial debt level, the efficiency of the tax system and the size of the external debt determine the position and steepness of the Bu curve
what is the Bu curve?
the benefit when default is not expected
what is the Be curve?
the benefit when the default is expected
why is the Be greater then the Bu?
it is greater because when default is expected, investors sell govt bonds, interest rates on govt bonds increase, govt budget deficit raises, more austerity is applied and so default becomes more attractive
when a solvency shock is not too big or too small then there exists two equally possible equilibria: one of default and one that does not lead to default. what decides on the selection of the equilibria?
the selection of one of these two points only depends on what investors expect. if investors expect a default there will be one whereas if investors do not expect a default then there will be none. this result is due to self fulfilling nature of expectations
what is the reason for the existance of the two equilibria in a incomplete monetary union?
it is the result of the liquidity constraint faced by the national governments in the incomplete monetary union.
