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Exchange rates and European monetary ystem

  2. 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
  3. FIXED AND FLEXIBLE EXCHANGE RATES Pros and Cons Optimum currency areas 3
  4. 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
  5. 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
  6. 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
  7. 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
  9. 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
  10. 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
  11. 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
  12. 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
  13. 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
  14. 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
  15. HYBRID SYSTEM Adjustable pegs, crawling pegs and managed floating 15
  16. 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
  18. 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
  19. THANK YOU 19