FLEXIBLE VERSUS FIXED EXCHANGE
RATES, EUROPEAN MONETARY
SYSTEM, AND MACROECONOMIC
POLICY COORDINATION
Savatore, 2015
Patcharawan Ubonloet
19 April 2016
GSPA NIDA

OUTLINE
 Fixed and Flexible exchange rates
- Pros and Cons
- Optimum currency areas
 European Monetary System and
The creation of the euro and
European Central Bank
 Hybrid system
- Adjustable pegs, crawling pegs and managed
floating
 International macroeconomic policy
coordination 2

FIXED AND FLEXIBLE
EXCHANGE RATES
Pros and Cons
Optimum currency areas
3

FIXED AND FLEXIBLE EXCHANGE RATES (ER)
 Fixed ER
 More stability to small opened economy which is
subject to large internal shocks with few trading partners
 Not allowing impact on decreasing in the volume
of international trade and investment leading to
destabilizing speculation and inflationary
 Disturbance are monetary (inflation)
 Flexible ER
 Believe that stability of speculation is
automatically adjusted by speculators
 Suitable for economy that have diversified trade and
majorly facing disturbances from real sector abroad i.e. Technology
and is subject to large external shocks i.e. Rise in export leads to
appreciation of national currency
 To achieve internal and external balance
 It was good for control money supply. However, it is reduced today
by international capital flow.
4

FIXED AND FLEXIBLE EXCHANGE RATES (ER)
Pros
 Stabilizes speculation
 Minimizes international trade
and investment risks
 Achieve price discipline which
balance of payment disequilibria
is fixed (no inflation) and
immediate changes in exchange
rate is impossible
 Requires discipline in economic
management
Cons
 Large holding of foreign reserve
required
 Fixed rates can also be
devalue/revalue
 Loss of internal policy (interest
rates) management freedom
Pros
 Allowing flexible rates to find its
own equilibrium
 Protects economy from other
countries’ economic volatility
 Minimize policy delay/mistakes
in using monetary policy
 Prevent gov’t from setting ER at
level other than equilibrium to
benefit one sector of economy on
expenses of others
Cons
 Greater volatility
 Encourages speculation
 Day-to-day fluctuation
discouraging specialization
in production and flow of
trade and investment
Fixed ER Flexible ER
5

OPTIMUM CURRENCY AREAS/BLOC
 Developed by Robert Mundell
and Ronald Mckinnon during 1960s
 A group of nations whose national
currencies are linked through permanently
fixed exchange rates and the conditions
that would make such an area optimum.
The currencies of member nations could then float jointly
with respect to the currencies of nonmember nations.
 In other words, geographical region in which it
would maximize economic efficiency to have entire
region share a single currency. 6

OPTIMUM CURRENCY AREAS/BLOC
Advantages
 Eliminates the uncertainty
 Stimulating specialization in
production, flow of trade and investments
 Single market and benefit from greater
economies of scale in production
 Greater price stability and
discourage inefficient barter deals
under inflationary circumstances
 Saves the cost of interventions in
foreign exchange markets
 Emigration of workers from poorer to richer nations
Conditions
for benefits
1. Mobility of resources
2. Structural similarity
3.Willing to coordinate
fiscal, monetary &
related policy
Disadvantages
Each member nation cannot pursue
its own independent stabilization and growth
policies adjusted to its particularly circumstance
7

EUROPEAN MONETARY SYSTEM AND
THE CREATION OF THE EURO AND
EUROPEAN CENTRAL BANK
8

EUROPEAN MONETARY SYSTEM AND
THE CREATION OF THE EURO AND
EUROPEAN CENTRAL BANK
 European Monetary System (EMS)
Main feature of EMS
 Creation of European Currency
Unit (ECU) weighted average of
the currencies of the member
nations
 Allowing the currency of each
EU member to fluctuate by
maximum of 2.25 percent on
either side of its central rate or
parity and jointly floating
against the dollar
 Establishment of the European
Monetary Cooperation Fund
(EMCF) to provide short- and
medium term balance-of-
payment assistance to members
9

TRANSITION TO MONETARY UNION
THREE-STAGE TRANSITION
1979
1991
1999
1998
EU to
form EMS
Maastricht Treaty
Convergence criteria
European Central Bank (ECB)
THREE-STAGE TRANSITION
1. Convergence of economic performance
and cooperation in monetary and fiscal
policy& removal of all restrictions to capital
movement
2. Creating a European Monetary Institute
(EMI) for European Central Bank (ECB)
3. Completion of monetary union by 1999
1989
European Monetary Union (EMU)
The euro (€) were trade in financial markets
and common monetary policy by ECB
After 1993 Countries
converted more to ECU
Value of ECU
= $1.1042
Stability and Growth Pact (SGP)
Budget deficit smaller than 3% of GDP to prevent
excessive money creation, inflation and a weak euro.
German couldn't’ meet the target.
1997
10

MAASTRICHT TREATY
Convergence Criteria
to the Monetary Union
1998,most members countries
met the most of the Maastricht criteria
Price stability
Inflation rate
< 1.5% point average of the three nations with
the lowest rate
Sustainable
public finance
Gov’t debt
< 60% of GDP
Durability of
convergence
Long-term interest rates
< 2 points more than the
average interest rates of the
three countries with the lowest
inflation rates
Sound public
finance
Budget deficit
< 3% of GDP
Exchange rate
stability
Average exchange rate
not falling by more than
2.25% of the average of the
EMS for the 2 years
5
11

THE CREATION OF THE EURO,
EUROPEAN CENTRAL BANK AND
THE COMMON MONETARY POLICY
 EMU
have 12 members of EU that have adopted
the euro as their common currency and have
established the ECB to conduct their common
monetary policy. Euro notes and coin became
the sole legal tender. Even though the euro
fluctuated in relation to other currencies, the
exchange rate of the participating currency
remained rigidly fixed in terms of euros as
earlier decided in 1998.
 ECB
The institution similar to the Federal Reserve
System in the U.S. that would not control the
money supply and issue the single currency of
the EU. It is responsible for the common EMU
monetary policy. It aims to pursue price
stability and political free.
12

ECB VERSUS FED
 European Parliament
has no power to
influence ECB’s decision
to prevent excessive
monetary stimulus and
thus inflation
 Maastricht Treaty can
be amended by
legislations/voters in
member countries for
ECB’s statute to change
 Congress can pass laws
to reduce independency
of FEB board
ECB FED
Criticized for being
undemocratic and
unresponsive to
economic needs of
citizens 13

CURRENCY BOARD ARRANGEMENTS
(CBAS) AND DOLLARIZATION
 CBA is the most extreme form of
a fixed exchange rate system.
 Adopted when in a financial crisis
and to combat inflation. i.e. Hong
Kong 1983 and Argentina 1991-2001
 The exchange rate arrangement
whereby the nation rigidly fixes
the exchange rate of its
currency to a foreign currency
or basket of currencies. i.e.
adopting the dollars as the nation’s
currency.
 Its central bank loses its ability to
1) Conductan independentmonetary
policy by allowing the nations
supply to increase or decrease only
in response to balance-of- payments
surpluses or deficits.
2) Act as lender of last resort
3) Collect seignorage from issuing
own currency
 Dollarization is further than CBA.
It is the situation whereby a nation
adopts another nation’s currency
asitslegaltenderi.e.Panama&Ecuador
 Advantages are
1) Avoiding cost of own currency to
dollars and hedge foreign exchange risks
2) Inflation and interest rate similar
to the U.S.
3) Avoid foreign exchange crises and
the need for foreign exchange and
trade controls
4) Fostering budgetary discipline
and promote more rapid and full
international financial integration
 Disadvantages
1) Cost of replacing the domestic
currency with the dollar
2) Loss of monetary and exchange
rate policies independency
3) Loss of central bank as a lender
of last resort to bail out domestic
banks in case of crisis
14

HYBRID SYSTEM
Adjustable pegs, crawling pegs
and managed floating
15

Nations monetary authority
intervene in foreign exchange
markets to smooth out short-
run fluctuations in exchange
rates without attempting to
affect their long-run trend.
The monetary authority
supply, out of international
reserves, a proportion of any
short-run excess demand for
foreign exchange in the
market (thus moderating the
tendency of the currency
depreciation) and absorb (to
add to its reserves) a portion of
any short-run excess supply of
foreign exchange in the
market (moderating the
tendency of the currency
appreciation)
HYBRID SYSTEM
ADJUSTABLE PEGS, CRAWLING PEGS AND MANAGED FLOATING
The system which exchange rates or
par values are periodically changed
to correct bop disequilibria. The band
of allowed fluctuation is very narrow.
Adjustable pegs
The system under which par values
or exchange rates are changed by very
small preannouncedamountsat frequent
and clearly specified intervals until the
equilibrium exchange rate is reached.
Nation set par value preventing
destabilizing speculation by manipulate
short-term interest rates so as to
neutralize profit from scheduled
change in exchange rate.
Crawling pegs
Managed floating
(Dirty float)
16

INTERNATIONAL
MACROECONOMIC POLICY
COORDINATION
17

INTERNATIONAL MACROECONOMIC POLICY
COORDINATION
 The modifications of national economic policies in
recognition of international interdependence.
 Obstacles
 Lack of consensus about the functioning of
international monetary system i.e. Whether money
expansion leads to increased output and employment
or only inflation
 Lack of agreement on policy mix required
because of identifying gains from the cost of
coordination and perhaps they are not very large or it
maybe of that inability to capture full benefits. 18

THANK YOU
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