Essay question: History shows us that attempts to fix exchange rates or create monetary unions between different countries usually end in failure. Therefore, we should not be surprised by the current problems in the Euro Zone. Discuss
“A monetary system is a set of policy tools and institutions through which a government provides money and controls the money supply in an economy”. The world has evolved through a variety of international monetary system since the 19th century. There have been three different international monetary system:
The Gold Standard
The Bretton-Woods system
Floating exchange rate
The Gold Standard
The Gold Standard last from1870 to 1914 and from 1918 to1939.
Under this system the countries fixed the price of their currency in terms of gold. All the currency’s prices were fixed in relation to the official gold reserve. The Gold Standard faced its first crisis during the first World War. Most of the countries to finance the cost of the war abandoned the gold standard and by doing so caused an increase in inflation to unsustainable levels.
Because this system limited the power of the central banks to supply money in an economy and therefore lower the interest rate, is easy to understand why the gold standard was blamed for prolonging the Great Depression during the interwar.
The Bretton-Woods system
The Bretton-Woods system or fixed exchange rates (1958-73) is based on the reserve currency hold by the central bank which fixes its currency exchange rate against the reserve currency by trading domestic for foreign asset when necessary. In this case the central bank fixed the dollar exchange rate of its currency by trading domestic currency for dollar assets. In the foreign exchange market, the central bank fixed the currency’s dollar price, and so the exchange rate was automatically fixed through arbitrage.
The Floating Exchange Rate
The floating exchange rate system (since 1973) is called the “non-system” because is characterized by less international policy coordinator than the other two system. Many countries under this system practise a managed floating exchange rate by buying currency and asset expecially during period characterized for high instability. In a floating exchange rate system the value of each currency is determined by the foreign exchange market without any intervention. An example is the European monetary system.
The Central Bank Intervention and the Money Supply
Many countries peg their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets. Many instead, with a flexible or “floating” exchange rate. This event is made possible by the central bank intervention and the money supply.
A purchase or a sale of any asset by the central bank will be paid for with check or currency. Any purchase/sale of domestic/foreign bonds will increase/decrease the domestic money supply causing the amount of money in circulation to shrink. Any transaction leads to a decrease or an increase of asset and liabilities in the central’s balance sheet:
Asset = Liabilities + Net Worth
where Net Worth is costant.
So an increase/decrease in asset lead to an increase/decrease in liabilities. A change in the central bank’s balance sheet lead to an equal change in currency in circulation or changes in deposits of banks, which lead to changes in the money supply.
How the Central Bank Fixes the exchange Rate
The foreign exchange market is in equilibrium when the domestic interest rate R is equal to R*, plus (Ee-E)/E, the expected rate of depreciation of the domestic currency against foreign currency. If the central bank do not intervene, the interest rate will rise above the foreign rate R* to balance the demand for money. So, for example, to maintain the domestic interest rate at R* the central bank must intervene in the foreign exchange market adjusting the money supply by buying foreign asset so that:
MS/P = L(R*, Y)
where P and Y are given, the equilibrium is achieved by the action of the central bank which supply enough money to adjust the exchange rate to the market equilibrium.
An example is given in the figure 1 where the equilibrium of the foreign exchange and the domestic money market is reached simultaneously when the exchnge rate is fixed at E0 and have to stay on E0 in the future. The market equilibrium is first at point 1 in the lower section of the figure. With a given price P and a national income level Y given, the money supply must be M1 with a foreign interest rate R equal to the domestic interest rate R*. In the upper part of the figure shows that if the foreign exchange rate is at point 1′, the equilibrium is given with R=R* and E0. But, as shows the figure, an increase in national income (from Y1 to Y2) lead to an increase of demand of real money shifing the aggregate real money demand downward to a new domestic interest rate (at point 3). So the bank, to return to R*, which rapresent the money market equilibrium equilibrium, must purchase foreign asset until the domestic money supply has reached M2. The new equilibrium, which is at point 2 in the figure, rapresent the new level of money supply necessary to have domestic interest rate again equals R* so that the foreign exchange market equilibrium remains at point 1′ and the equilibrium exchange rate still equal to E0.
Asset Market Equilibrium with a Fixed Exchange Rate, E0
Monetary and fiscal Policy under a Fixed Exchange Rate
The central bank can fix any level of exchange rates through monetary policy or through fiscal policy. But as seen above, with a fixed exchange rate is impossible for the central bank to influence the economy through monetary policy. Only with a fiscal policy the central bank can still influence output and employment. In same case, the central bank can decide to change the level of the foreign currency value of the domestic currency. This can occur because its current account deficit is largest than its capital financial inflow. In this case can occur case of Devaluation or revaluation:
Devaluation For devaluation to occur, the central bank buys foreign assets, so that domestic monetary assets increase and domestic interest rates fall, causing a fall in the rate return on domestic currency deposits. When the central bank make less valuable the domestic currency price of foreign currency raising E. Revaluation when the domestic currency is made more valuable lowering E.
The fgure 2 shows the effect of a currency devaluation where E is devalued to E1 and the equilibrium is moving toward point Y2 where the demand is expanded.
The Financial Crisis and The Capital Flight
A crisis, or technically, a balance of payment crisis occurs when a central bank have not enoght international reserves asset to mantein the exchange rate R* fixed. Changes in a central bank’s balance sheet lead to changes in the domestic money supply. Buying domestic or foreign assets increases the domestic money supply. Selling domestic or foreign assets decreases the domestic money supply.
Domestic assets must offer high interest rates to stimulate investors to hold them. The central bank can push interest rates higher by reducing the money supply (by selling foreign and domestic assets). As a result, the domestic economy may face high interest rates, a reduced money supply, low aggregate demand, low output, and low employment.
The recent crisis has been linked to changes in the international foreign markets, which since the early 1980s have been deregulated. The majority of exchange rate transaction are connected with currency speculation(see Euro) or with short term capital flows (hot money). This capital is substantial and can flow around the world exceptionally quickly.
In open economies, policy maker can protect a fixed exchange rate by using foreign currency and gold reserves. The large increase in foreign exchange turnover can lead to strong devaluation. As a result, financial capital is quickly moved from domestic assets to foreign assets: capital flight.
The figure 3 shows the capital flight, the interest rate and the money supply.
When a central bank ends its official international reserve assets, it needs to devaluate the domestic currency. As the figure shows, the asset market is I equilibrium in the money market (at point 1) and in the foreign exchange market (at point 1′) with a fixed exchange rate E0. To hold the exchange rate fixed at E0, after the devaluation to E1, the central bank must use its reserve to finance a private financial outflow that will increase the interest rate and reduce the money supply.
In practice , since the current exchange rate is E0, the equilibrium in the exchange market (point 2′) requires an increase in the domestic interest rate, so that:
R* + (E1 –E0 ) / E0
Now R is equal to R*, the expected domestic currency return on foreign currency asset.
To exchange for 1 uniti of foreign currency(asset) it needs more domestic currency(asset). In this way, the central bank replenish its foreign assets by:
buying them back a devalued rate reducing interest rates, increasing money supply,
reducing the value of domestic products,
increasing aggregate demand, output and employment over time.
But what happen when the expected interest rate of return are not the same:
R > R*+(Ee –E)/E
then, the rates of return are not the same of expected there are two different risk:
Exchange rate risk
Default risk: The risk that the country’s borrowers will default on their loan repayments. Lenders therefore require a higher interest rate to compensate for this risk.
Exchange rate risk:If there is a risk that a country’s currency will depreciate or be devalued, then domestic borrowers must pay a higher interest rate to compensate foreign lenders.
Once a country is under attack from speculators, it may have problem in fixing its exchange rate. High interest rates have different impact on the rest of the economy. Speculators, when expect that the country will devalue, require higher interest rate to compensate for the potential caital loss. In cases of significant unemployment, high public debt and bank crisis will make rises in interest rate more unbearable.
In brief there are three reason are leading to a potencial crisis:
when a governament wish to abandon the fixed exchange rate. when a governament defend the exchange rate and people expect that it might be abandoned. when the cost of defending a currency became unbearable.
Euro and Economic Policy in the Euro Zone
Euro was born on January 1, 1999. The main reason were:
a monetary policy coordination
a mutual exchange stability
to enhance the role of Europe, its prestige and credibility around the world to turn the European Union into a unified market
The first important istitution was the European Monetary System(EMS). With a mixture of policy cooperation it aimed to restrict the exchange rate within specified fluctuattion margin. An economic and monetary union (EMU) has been reached with the Mastrict Treaty, on december 10, 1991.
The European integration process has given to the Europea Union a better and stronger position in international affairs. But, it was the right choice? Attempts to reach a monetary efficiency gaing from joining the fixed exchange rate system have been helpful? Looking at the situation now, the answer is not. Euro zone is under speculation attack since 2008. The attempts to create a optimum currency area (OCA) in the Euro zone have been in vain. The idea of a high degree integration between and a fixed exchange rate area is vanishing. An optimal currency area is a region or area where economies are closely linked by trade and have a high factor mobilities.
The entire area is characterized by a high account deficit. To prevent crisis, or a speculative attack on a fixed exchange rate, the policy maker needs huge reseves to defend the currency. But sometimes, it is impossible or too coostly to defend the parity in the exchange market.
What can be done?
Capital requirements and asset restrictions. A highly capitalised bank is less likely to default as it can always draw on its own capital.
Lender of last resort. It can be used to avaid the collapse of one bank to provide liquidity in times of crisis.
Banking supervision. Regulators would check the banks’ books, ensure capital compliance, prevent risky loans and undiversified loan structures, etc.
Deposit insurance. By insuring small depositors against bank default. This type of insurance can protect private investors and raise moral hazard issues.
Is the euro zone an optimum currency area?
Looking at our analysis of the European economic structure we can conclude that the EU economies are open to trade and that capital is highly mobile. However, we must agree that labour is largely immobile for linguistic and cultural reasons, as well as for personal and social costs of migration. There is evidence that national financial markets have become better integrated with each other as a result of the Euro. Since the introduction of the euro, we have seen improvement in financial integration, inflation convergence and trade openness. On the contrary, labour mobility and wage flexibility remained low.
In conclusion, the Euro zone is not an optimal currency area. Efforts are needed on many fronts in order to make the Euro zone an optimal currency area. In a situation characterized by a fiscal solvency (that usually requires austerity) and economic stagnation, how to restore competitiveness?
A solution could be the return to the Gold Standard. But, why the gold standard? The gold standard provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade. Long-term price stability has been described as the great virtue of the gold standard. The gold standard makes it difficult for governments to inflate prices through issuance of paper currency. Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible. The return to the gold standard will provide stability to monetary policy rather than allowing decisions about monetary policy to be made on the basis of politics.
Krugman, Paul R., and Maurice Obstfeld. 2009. “Case Study: Is Europe an Optimum Currency Area?” In International economics theory & policy, Boston, Mass.: Pearson, Addison-Wesley, pp. 582- 587.
John Sloman, Alison Wride, 2011 . Economics, eight edition. Pearson, chapter 20.
Krugman, Paul R., and Maurice Obstfeld. 2012. International Economics: Theory and Policy, ninth edition.Chapter 18-19-20-21.
Levi, M., International Finance, London:Taylor and Francis, 2009, Chapter 10 and 11.
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