European Monetary System

1. European Monetary System Credits: E. de Souza, P. Mathew.

2. Contemporary Currency Regimes • Free Float • The largest number of countries, about 48, allow market forces to determine their currency’s value. • Managed Float • About 25 countries combine government intervention with market forces to set exchange rates. • Pegged to (or horizontal band around) another currency • Such as the U.S. dollar or euro • No national currency • Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

3. Arguments in favor of flexible exchange rates: Easier external adjustments. National policy autonomy. Arguments against flexible exchange rates: Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises. Currencies depreciate (or appreciate) to reflect the equilibrium value in flexible exchange rates Governments must adjust monetary or fiscal policies to return exchange rates to equilibrium value in fixed exchange rate regimes Fixed vs. Flexible Exchange Rate Regimes

4. Fixed versus Flexible Exchange Rate Regimes • Suppose the exchange rate is $1.40/£ today. • In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. • The U.S. experiences trade deficits.

5. Supply (S) Demand (D) $1.40 Trade deficit S D Fixed versus Flexible Exchange Rate Regimes Dollar price per £ (exchange rate) Q of £

6. Flexible Exchange Rate Regimes • Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/£, the price at which supply equals demand and the trade deficit disappears.

7. $1.60 Dollar depreciates (flexible regime) Fixed versus Flexible Exchange Rate Regimes Supply (S) Dollar price per £ (exchange rate) Demand (D) $1.40 Demand (D*) Q of £ D = S

8. Fixed versus Flexible Exchange Rate Regimes • Instead, suppose the exchange rate is “fixed” at $1.40/£, and thus the imbalance between supply and demand cannot be eliminated by a price change. • The government would have to shift the demand curve from D to D* • In this example this corresponds to contractionary monetary and fiscal policies.

9. Fixed versus Flexible Exchange Rate Regimes Supply (S) Contractionary policies Dollar price per £ (exchange rate) (fixed regime) Demand (D) $1.40 Demand (D*) Q of £ D* = S

10. European Monetary System (EMS) • EMS was created in 1979 by EEC countries to maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. • Objectives: • Establish zone of monetary stability • Coordinate exchange rates vis-à-vis non-EMS countries • Develop plan for eventual European monetary union • Exchange rate management instruments: • European Currency Unit (ECU) • Weighted average of participating currencies • Accounting unit of the EMS • Exchange Rate Mechanism (ERM) • Procedure by which countries collectively manage exchange rates

11. 1 Euro is Equal to: 40.3399 BEF Belgian franc 1.95583 DEM German mark 166.386 ESP Spanish peseta 6.55957 FRF French franc .787564 IEP Irish punt 1936.27 ITL Italian lira 40.3399 LUF Luxembourg franc 2.20371 NLG Dutch guilder 13.7603 ATS Austrian schilling 200.482 PTE Portuguese escudo 5.94573 FIM Finnish markka What Is the Euro (€)? • The euro is the single currency of the EMU which was adopted by 11 Member States on 1 January 1999. • These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. • Prominent countries initially missing from Euro : • Denmark, Greece, Sweden, UK • Greece: did not meet convergence criteria, was approved for inclusion on June 19, 2000 (effective Jan. 2001) Euro Conversion Rates

12. Benefits and Costs of the Monetary Union • Transaction costs reduced and FX risk eliminated • Creates a Eurozone – goods, people and capital can move without restriction • Compete with the U.S. • Approximately equal in terms of population and GDP • Price transparency and competition • Loss of national monetary and exchange rate policy independence • Country-specific asymmetric shocks can lead to extended recessions

13. The Long-Term Impact of the Euro • If the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. • It is likely that the U.S. dollar will lose its place as the dominant world currency. • The euro and the U.S. dollar will be the two major currencies.

14. Bretton Woods Regime(fixed exchange rates) • Stable exchange rates, but adjustable • US dollar fixed in terms of gold ($35 an ounce) • fixed parity for other currencies in terms of dollar • band around dollar parity: plus or minus 1.0 % • adjustment of parities after consultation with the IMF • adjustments discouraged, allowed in case of serious balance of payments disequilibria, postponed by IMF loans • Central Banks of member countries hold reserves in gold or dollars • and have right to sell dollars for gold to Federal Reserve

15. Bretton Woods Regime(fixed exchange rates) • Consequences • dollar becomes the international currency (international dollar standard or gold exchange standard) • dollar takes on role of reserve currency (interest bearing) • Central Banks must intervene in foreign exchange markets to stabilise the exchange rate of their currencies by buying and selling dollars

16. Problems of B-W regime • Problem 1: Nth Currency Problem • two currencies means one exchange rate • (N currencies mean N-1 independent exchange rates) • both countries cannot independently fix the exchange rate. • EITHER both co-operate (symmetric solution) • OR one follows a policy of “benign neglect” (asymmetric solution). Role played by the USA • Problem 2: Realignments • definition: changing the exchange value of a currency. • rendered difficult by the rules of the regime • postponed as much as possible. • Result:

17. Problems of B-W regime • Problem 3: Speculative attacks • Exchange rate value loses credible • Massive sales (normally) or purchases of the currency. • Breakdown of Bretton-Woods regime • Inflation rises in the United States of America • accelerates because of expansionary fiscal and monetary policies (Vietnam war) • Two effects • Purchasing power value of US$ falls • Other countries “import” American inflation. • Markets start selling dollars in large quantities • Movement started by request of the Banque de France (de Gaulle) to USA to convert its dollar holdings into gold (“exorbitant privilege”).

18. Problems of B-W regime • Breakdown of Bretton-Woods regime (cont’d) • August 15th 1971. Nixon closes “gold window” • December 1971. Smithsonian Agreement: general realignment and increase of band to plus or minus 2.25% March 1973: free floating • Strong fluctuations of European currencies against the dollar – and, therefore, even stronger fluctuations between the European currencies • In this context, the European Monetary System (EMS) is born. • 1976: Jamaica Agreements (official end to Bretton-Woods period)

19. How EMS addressed Bretton-Woods Regime Problems • Asymmetry • introduction of ECU • a basket of currencies of all Member States • each currency in the basket assigned a weight • the weight could change over time • replaced European Unit of Account

20. The ECUA basket of all EC currencies Belgian franc = Belgian (3.301) and Luxembourg (0.13) franc

21. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • introduction of an Exchange Rate Mechanism • participation in ERM not obligatory • each participating currency assigned a (bilateral) central parity with respect to each of the other participating currencies (defines a parity grid ) • maximum variation of 2.25% on either side of central parity allowed • Italy granted exception of 6% on either side.

22. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • obligatory and unlimited intervention at the margin • suppose 1 DEM equalled 20 BEF (central parity) • market exchange rate could vary between 19.55 and 20.45 BEF • if market rate reached either bound, both the Belgian National Bank and the German Bundesbank had to intervene in the market

23. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • obligatory and unlimited intervention at the margin (cont’d) • if the exchange rate rose to 20.45 (appreciation of mark and depreciation of franc) • the Bundesbank and the Belgian National Bank would have to sell marks and buy francs • German Bundesbank at an advantage because it could print as many marks as it needed • Belgian National Bank at a disadvantage because it had a limited stock of marks to sell. • Why oblige both to intervene?

24. How EMS addressed Bretton-Woods Regime Problems • Asymmetry (cont’d) • obligatory and unlimited intervention at the margin (cont’d) • because as a result of the intervention, the German money supply increased and the Belgian money supply decreased • German interest rates fell and Belgian interest rates rose, stabilising the exchange rate

25. How ERM addressed Bretton-Woods Regime Problems • Realignment • At the request of one or several countries participating in the ERM, a consultation occurred involving the Ministers of Finance and the Governors of the Central Banks of all the participating countries. • These decided whether and to what extent a realignment should take place. • Consequently, realignments were carried out rapidly and with the agreement of the participating countries. • The consultation often limited the extent of the realignment out of fear of loss in competitiveness.

26. How ERM addressed Bretton-Woods Regime Problems • Speculative Attacks • obligatory and unlimited interventions by the two Central Banks whose currencies were involved • markets would then know that between them the Central Banks would not run out a currency • this would reduce the probability of a speculative attack

27. Functioning of ERM of EMS • Four phases in the functioning of the ERM • March 1979 to March 1983 • Participating countries going there own way policy-wise. 7 realignments. • April 1983 to January 1987 • Participating countries beginning to recognise the constraints on policy imposed by the ERM. 4 realignments. • February 1987 to September 1992 • The “hard” EMS. 1 “technical” realignment (Italy). • October 1992 to end 1998 • the period following the “breakdown” of the EMS and preceding monetary union

28. Functioning of ERM of EMS • Four phases in the functioning of the ERM

29. Functioning of ERM of EMS

30. Functioning of ERM of EMS • Why did the ERM “break down” in Sep. 1992? • Remote causes • the system had become too rigid • markets convinced no more realignments before monetary union (Delors effect) • loss of competitiveness of certain countries • large capital flows into high interest rate countries (Italy, Spain and Portugal) • is this compatible with interest rate parity? • risk premium.

31. Functioning of ERM of EMS • Why did the ERM “break down” in Sep. 1992? • Remote causes (cont’d) • the system had become asymmetric and dependent on Germany • the Bundesbank set the interest rate for Germany • the other ERM countries tied their currencies to the German mark • the other ERM countries adapted their interest rate to Germany’s • In the ERM, Germany played the role that the USA played under Bretton-Woods

32. Functioning of ERM of EMS • Why did the ERM “break down” in Sep. 1992? • Proximate causes: • capital flows (liberalisation of capital flows in 1990) • the Bundesbank hikes up its interest rate after re-unification • Maastricht Treaty vote in Denmark and in France • Solution: either floating exchange rates or move to monetary union • Britain chose floating • as did Italy and Spain temporarily • fluctuation margins increased to 15% on both sides of central parity

33. Transition to a Monetary Union • The Delors Report • The Maastricht Treaty • The 3 stages • Stage Two: preparing for monetary union • establishment of the European Monetary Institute • countries shall endeavour to avoid excessive fiscal deficits • the criteria for membership • Stage Three: monetary union

34. Cost – Benefit Analysis

35. Monetary Policy Strategy • The “two pillar” framework for the assessment of the risks to price stability • an “economic analysis” pillar (short term) • assessment of current economic developments and associated short to medium-term risks to price stability. Includes an analysis of shocks hitting the euro area economy and projections of key macroeconomic variables • a “monetary analysis” pillar (medium term) • developments in a wide range of monetary indicators including M3, its components and counterparts, notably credit, and various measures of excess liquidity.

36. Monetary Policy Strategy • The “two pillar” framework for the assessment of the risks to price stability • a “monetary analysis” pillar • a “reference value” for the rate of growth of the monetary aggregate, M3, is calculated on the basis of the quantity theory of money: • rate of growth of money stock = inflation rate + trend growth rate of output – rate of change in velocity of circulation of money = (below 2 %) + (2 % to 2.5 %) – (-0.5 % to –1 %) = (more or less) 4.5 %

37. Monetary Policy Strategy Rate of growth of M3 (“reference value: 4.5%)

38. Monetary Policy Instruments • a. Standing facilities • marginal lending facility (ceiling) • no bank will borrow for more • deposit facility (floor) • no bank will lend for less

39. Monetary Policy Instruments (cont’d) • b. Open market operations • buying and selling government bonds to “counterparties” (financial institutions with whom the ESCB deals directly) • open market operations allow the Central Bank to steer the interest rate within the bounds.

40. Monetary Policy Instruments (cont’d) • c. Minimum Reserves • banks have to deposit at the ESCB a certain percentage of the deposits they themselves receive from clients. Which means that liquidity is withdrawn from the system. But also affects the profitability of banks who are paying interest on these deposits to clients but cannot lend them to others.

41. 4. Exchange Rate Policy • Who is responsible ? • It is the responsibility of the Council, in virtue of Article (EC) 111 and by way of derogation from Article (EC) 300, acting on a recommendation of the Commission or the ECB. • It must act unanimously if it concerns (i) “conclud[ing] formal agreements on an exchange rate system for the ECU in relation to non-Community currencies”; • by a qualified majority if it concerns (ii) “adopt[ing], adjust[ing] or abandon[ing] the central rates of the ECU within the exchange rate system”, or (iii) “in the absence of an exchange rate system in relation to one or more non-Community currencies Y formulat[ing] general orientations for exchange-rate policy”. • The ECB must be always be consulted “in an endeavour to reach a consensus consistent with the objective of price stability” in the first two cases, and “without prejudice to the primary objective of the ECB to maintain price stability” in the third case.

42. Exchange Rate Policy • Fixed Exchange rate policy vis-à-vis Pre-ins (ERM 2) • participation is voluntary • hub and spoke: the Euro is the hub. • unlimited intervention by both parties, UNLESS danger to price stability • actual participants: Denmark, Estonia, Lithuania and Slovenia • Exchange rate policy vis-à-vis the Rest of the World • floating exchange rates • external representation of the Euro-area countries (see further)

43. External representation of the Euro-Area countries “The President of the ECB (replacing the national central bank governors from the euro area) and the President of the EuroGroup will take part in the meetings of G7 Finance Ministers when the world economic situation, multilateral surveillance and exchange rate issues are being discussed. The Commission will be involved to the extent required to enable it to perform the role assigned to it by the Treaty, and it will attend the meetings in connection with specific issues, to be determined by the Ministers.” Furthermore, the ECB has been granted observer status at the International Monetary Fund where only the governments are represented. The Economic and Monetary Union will be represented by the president of the Euro-area countries assisted by a representative of the Commission.

44. The Stability and Growth Pact

45. Stability and Growth Pact • Origins of the Pact (to caricature a bit) • French considered ESCB statutes a necessary evil to bring Germany into a monetary union • France wanted a strong countervailing power • Germany refused a monetary union without some economic convergence • Germany wanted rules to maintain fiscal discipline once monetary union achieved

46. The Macroeconomic Role of Fiscal PolicyThe Stabilisation Role • Automatic Fiscal Stabilisers (no gov’t action required). • A rise in output increases tax revenues and decreases government expenditures. This dampens the increase in output. • A fall in output lowers tax revenues and raises government expenditures. This increases output. • Discretionary Fiscal Policy. • Policy changes in gov’t. expenditures and/or revenues. • Cyclically Adjusted Budget Deficits (CAB). • Actual budget deficits minus the automatic changes.

47. Why Fiscal Rules? • Historical Background • In the 1980s, there was a large accumulation of government debt in most OECD countries, which was unprecedented in peacetime. • As a consequence, fiscal sustainability became the main fiscal policy issue, and major reforms of the fiscal policy framework were undertaken in nearly all OECD countries.

49. The Stability and Growth Pact (SGP) • Legal Basis • Article 99 of the EC Treaty - multilateral surveillance • through monitoring of economic policies and the publication of Broad Economic Policy Guidelines • Article 103 of the EC Treaty –“no bail out” clause • Article 104 of the EC Treaty - Excessive Deficit Procedure (EDP) • procedures for establishing existence of, and taking effective action against, excessive deficits and debt levels. • Protocol on EDP annexed to the Treaty • definition of reference values for excessive government budget deficit and debt; and other details.

50. The Stability and Growth Pact (SGP) • Relevant texts • Council Regulation 1466/97 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies [the “preventive arm”] • aims, through regular surveillance, at preventing budget deficits going above the 3% reference value. Requires the submission of stability and convergence programmes. • imposes a medium-term objective of a government budget close to balance or in surplus • measured in cyclically adjusted terms (see Code of Conduct) • Council Regulation 1467/97 on speeding up and clarifying the implementation of the EDP [the “dissuasive arm”] • in the event of the 3% reference value being breached, requires Member States to take immediate corrective action, and, if necessary, allows for the imposition of sanctions. Council can provide an “early warning” of an eventual deficit.