The management of the exchange rate in EuropeCNAM- INTERNATIONAL INSTITUTE OF MANAGEMENT AND INSTITUTUL NATIONAL DE DEZVOLTARE ECONOMICA (INDE)(Academiei de Studii Economice din Bucurestu) BUCHAREST, October 2013, 25 and 26Jacques ISSOULIEBanque de France

Definition of the exchange rate

Nominal echange rate

Real exchange rate

Movements in the nominal and real exchanges rates

The exchange rate in the long run: the purchasing power parity

Relative or absolute PPP

Other determinants of the exchange rate in the long run

The interest parity condition

Exchange rate regimes

Floating rates

Fixed exchange rates

The impossible trinity principle

Monetary integration

The snake

The European monetary system

The convergence criteria

Optimum currency areas theory

18 members of the eurozone

The euro crisis

WHAT IS THE EXCHANGE RATE ?The nominal exchange rate ?Exchange rates can be quoted in two ways.

In British terms, you get the number of foreign currency units per domestic unit, that is to say, for example, USD 1,5 per EUR 1.

In European terms, you get the number of domestic currency units needed to buy one unit of foreign currency, for example, in the case of Switzerland, we have CHF 1,6 per EUR 1.

Nominal exchange rateIf we adopt the British terms convention, an appreciation of a currency corresponds to an increase in its value in terms of foreign currencies , so that the exchange rate rises.

Conversely, a loss of value, or depreciation, implies a decline in the echange rate.

The real exchange rate ?

Nominal exchange rates compare the relative prices of different currencies but they dont say anything about how much one can buy with each currency.

Prices in two different countries cannot be compared directly since they are expressed in different currencies. Before any comparison, we must convert prices into the same currency.

Real exchange rateReal exchanges rates normally compare broad price indices such as the CPI.

The real exchange rate is the ratio of the average prices of baskets of goods in two different prices.

The real exchange rate = S P/P*

With S = nominal exchange rate, P the price index in the first country and P* the price index in the second country

Movements in nominal and real exchange ratesThe rate of change of the real exchange rate)

= rate of change of the nominal exchange rate + domestic inflation rate foreign inflation rate.

The real exchange rate is driven by the nominal exchange rate and the inflation differential .

Movements in nominal and real exchange rates

Exchange rate appreciation = foreign inflation rate domestic inflation rate.

If inflation is durably lower than abroad, our currency should appreciate in the long run.

A country with higher inflation sees its exchange rate depreciate vis--vis the currency with a lower inflation rate.

Movements in nominal and real exchange rates

Since inflation differentials reflect differences in money growth, the evolution of the nominal exchange rate is driven by relative money growth rates.

In the short run, there is no visible link between the exchange rate , money growth and inflation (the nominal exchange rate is very volatile, even more than the money stock, while price differentials are much more stable).

Movements in nominal and real exchange ratesA real appreciation is a loss of competitiveness, as goods become expensive relative to foreign goods.

This happens when the nominal exchange rate appreciates or when domestic inflation exceeds foreign inflation.

Measuring the real exchange rate ?A country usually has several commercial partners.

We often calculate an average exchange rate and an average foreign price level using weights that reflect the relative importance of the partner.

The external terms of trade is the ratio of domestically produced exports to foreign produced import prices.

The internal terms of trade is the ratio of non traded to traded goods prices.

You may also compare the prices of labour.

The exchange rate in the long run: purchasing power parityThe PPP principle means that the real exchange rate is constant over the long run.

The relative PPP is a natural implication of money neutrality. As nominal variables, the nominal exchange rate and the price level are not expected to durably affect real variables, including the real exchange rate.

The relative PPPThis is a manifestation of the dichotomy principle. In the long run, the domestic money supply proportionally affects domestic prices the same holds abroad but not the real exchange rate.

The relative PPPThe logic is simple. Suppose that monetary policy is more expansionary at home than abroad. With money growing faster, we expect inflation eventually to be higher at home.

If the nominal exchange rate remains unchanged, the real exchange rate appreciates. This means that domestic goods and services become expansive relative to foreign goods and services.

As a result, domestic producers gradually lose competitiveness. Because of the increase in prices, the nominal exchange rate will depreciate and this will tend to restore competitiveness.

If it depreciates by the full amount of the accumulated inflation differential, the loss of competitiveness is entirely erased.

Thus, up to a certain extent, the PPP asserts that in the long run, a country must retain its competiveness.

The absolute PPPThe law of one price posits that the same good should trade everywhere at the same price when prices are expressed in the same currency.

If prices were differents, arbitrages would take place until prices get equalized.

That prices of the same goods are the same in different countries leads to the absolute PPP principle.

Absolute PPP requires not only that the real exchange rate be constant but that it be equal to unity.

What to think of PPP ?Relative PPP appears as a pretty good rule of thumb.

Absolute PPP is rather not respected.

Other determinants of the exchange rate IN THE LONG RUN.The real exchange rate is related to the primary account surplus: the current account deteriorates when the real exchange appreciates.

A reminder: the current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports net earnings on imports), factor income (earnings on foreign investments payments made to foreign investors) and cash transfers.The capital account records the net change in ownership of foreign assets. BOP = current account capital account + or balancing items (statistical errors).

The short run and the long run exchange ratesThe short run view is linked to financial markets, to the exchange rate market.

The long run view is linked to the relative price of goods view.

The current nominal exchange rate is linked to the expected future exchange rate.

As regards the future, a good bet is that (in the long run) the relative price of goods view will prevail.

The interest parity condition

IRP: returns on similar assets cannot differ systematically across countries when there is free trade in financial assets, when financial capital is perfectly mobile.

Financial traders constantly scan the whole world and can instantly move huge amounts of money at virtually no cost.

As a result, the IRP is satisfied virtually always and any deviation is immediately corrected.

IRP does not hold in presence of capital restrictions.

The open economy and the interest rate parity condition

When the domestic interest rate is low relative to interest rates elsewhere in the world, international investors are likely to borrow at home to lend abroad.

That will result in outflows of capital and sales of the domestic currency.

It will lead to a depreciation of the nominal exchange rate.

The central bank must decide what it wants to do.

The importance of flows often makes the situation unsustainable.

The domestic interest rate will have to move to the world level.

stors are likely to borrow at home and use the proceedings to lend abroad.

The interest rates in different countries are closer the less the exchange rate diverges.

Borrowing at home and investing abroad means initially converting the borrowed amounts into the foreign currency and moving funds in the opposite direction when the arrangements mature.

If in the meantime the domestic currency appreciates, the value of the foreign invesment will decline (capital loss).

International financial markets are in equilibrium when capital flows of this kind are unnecessary because the returns on domestic and foreign assets equalized.

This property of international financial markets is called the interest rate parity condition.

It can be stated as domestic interest rate = foreign interest rate + expected exchange rate depreciation.

Foreign interest rate + expected exchange rate depreciation = return on foreign assets.

Interest rate parity links the domestic interest rate to foreign returns, the latter including capital gains or losses

Exchange rate regimesWe distinguish fixed (and adjustable) or fully flexible (or free float).

When they are freely floating, exchange rates are continuously priced on foreign exchange markets.

Central banks intervene through selling or buying their own currency against other currencies.

When it adopts a fixed exchange rate regime, a central bank commits to keep the exchange rate within a declared band of fluctutation.

If the currency weakens, the central bank buys it back, selling some of its foreign exchange reserves.

Freely floating ratesIf the currency strengthens, the central bank sells it and accumulates more foreign exchange reserves.

If the domestic interest rate is below the foreign rate, this triggers capital outflows and sales of the domestic currency.

The exchange rate depreciates.

If we suppose that prices are constant, a nominal depreciation translates into a real depreciation which makes our goods and service more competitive.

This results in an increase in exports.

This results in an increase in GDP/national income.

The movement stops when the interest rate is again equal to the foreign rate

An increase in the money supply will decrease the interest rate and thus affects the exhange rate and competitiveness (that is why monetary policy works)

The case for flexible exchange ratesWhen shocks occur (national or international recessions, oil shocks, technological change) prices must be adjusted to avoid deepening cyclical fluctuations. When prices and wages are sticky, the required adjustment may take far too long. Flexible rates provide the fast way to adjust relative domestic and foreign costs and prices.

Exchange rates and politics: an appreciation or a depreciation affects income distribution (appeciation = consumers find imported goods cheaper but exporters must compress profit margins and maybe labour costs to remain competitive) (depreciation = it hurts the consumer and benefits the producers) and is perceived as a judgement on the governments competence. Depreciation = failure. Removing the exchange rate from the political field is desirable.

Difficulty to renounce the convenience of MP autonomy.

Fixed exchange rateMoney supply increases > the interest rate decreases > capital outflows and sales of the currency > exchange rate depreciation.

But, the central bank does not let the exchange rate depreciate.

It sells its reserves, buying the currency back.

It re-absorbs sole of the money it has created > the money supply shrinks.

The interest rate starts increasing again.

In practice, exchange rates are rarely rigidly fixed and are usually allowed to move within bands.

According to the width of the band, the room for monetary independance is more or less extended.

For small economies, the price level is determined by the foreign price level.

The case for fixed exchange ratesTendency of exchange markets to misbehave + Cases where exchange rate policy is useful.Exchange markets = short-term financial logic + information about the future: essential but highly imperfect. Fads, rumours and herd behaviour > panicsMarket gyrations provoke at least large fluctutations > uncertainty > curb trafe and foreign investmentHarnessing MP to an exchange rate target introduces discipline since markets sanction inflationary policiesIn case of serious shocks, parity realignments are always possible (fixed but adjustable). Adopting a parity is not a permanent commitment but rather an anchor for MP.

The impossible trinity principleIn a fixed exchange rate regime, monetary policy is lost as an autonomous instrument of economic policy while it is fully available when the exchange rate is floating.

Choosing an exchange rate regime is choosing a monetary policy (autonomous or not).

When a country forms a monetary union with other countries, it loses monetary policy as an instrument of monetary policy.

More precisely, the loss that matters is the short run loss since, in the long run, monetary policy is neutral.

The true implication is that the inflation rate is no longer established by domestic authorities (this may be desirable for inflation-prone countries).

One way of escaping choosing between exchange rate stability and monetary policy autonomy is to restrict capital movements.

Many European countries operated capital controls until the early 1990s when full capital mobility was made compulsory.

Many of the new members only abandoned controls upon accession.

The logic of monetary integrationOnly two of the three following features can be simultaneously in place:- full capital mobility- autonomous monetary policy- fixed exchange rates.

Full capital mobility and autonomous monetary policy: MP is effective but the central bank cannot control the exchange rate (Eurozone and US).

Full capital mobility and fixed exchange rate: loss of MP and the central bank dedicates itself to upholding the fixed exchange rate commitment, maybe by exploiting the limited room for manuvre made possible by a margin of fluctuation (current ERM members).

Fixed exchange rate and monetary policy autonomy: capital controls block the interest parity principle. This combination was widespread under the Bretton Woods system. Most developing countries followow this strategy.

Snake in the tunnelThe Basle agreement in 1972 (10 April 1972) between the six existing EEC members and three about to join (the pound sterling, the Irish punt and the Danish crown) established a snake in the tunnel.

Bilateral margins between currencies limited to 2,25% implying a maximum change between any two currencies of 4,5%.

The tunnel collapsed in 1973 when the USD floated freely.

The snake proved unsustainable.

In 1977, it had become a DM zone with the Belgian and Luxembourg franc, the Dutch guilder and the Danish krone.

The European Monetary systemIn March 1979, the EMS replaced the European Currency snake.

Elements of the arrangement:

The ECU: a basket of currencies preventing movements above 2,25% around parity in bilateral exchange rates with other member countries.An Exchange Rate Mechanism (ERM).An extension of European credit facilities.The European Monetary Cooperation Fund (allocates ECUs to member central banks in exchange for gold and USD deposits).

Several crisis: 1986, 1992

The monetary unionThe MAASTRICHT TREATY (adopted on 10 December 1991).

Stage 1 (1990): full liberalisation of capital movements.

Stage 2 (1994): creation of the EMI, forerunner of the ECB.

Stage 3 (1997): launch of the monetary union and introduction of the euro.

The EMU and the euroThe EMS was replaced by the ERM 2 on 1 january 1999.

The ECU basket was discarded and replaced by the euro.

The ERM 2 is a waiting room for joining the EMU.

In the EMU the currencies of member states are replaced by the euro.

Convergence criteria (art 121 (1) of the EC treaty)Price stability. The achievement of a high degree of price stabilitywill be apparent from a rate of inflation which is close to that of, at most, the three best-performing member states in terms of price stability. In practice, the inflation rate of a given member state must not exceed by more than 1,5% that of the three best-performing member states in terms of price stability during the year prededing the examination of the situation in that member state.

Government finances. The sustainability of the governement financial positionwill be apparent from having achieved a government budgetary position without a deficit that is excessive. In practice, 2 crieria:

- the annual government deficit. The ratio of the annual governement deficit to GDP must not exceed 3% at the end of the preceding year.

- government debt. The ratio of gross government debt to GDP must not excced 60% at the end of the preceding financial year.

Exchange rates. The member state must have participated in the ERM 2 without any break during the two years preceding the examination of the situation and without severe tensions.

In addition, it must not have devaluated its currency (the bilateral central rate for its currency against any other member states currency) on its own initiative during the same period.

Long-term interest rates. In practice, the nominal long-term interest rate must not exceed by mote than 2% that of, at most, the three best-performing member states in terms of price stability. The period taken into consideration in the year preceding the examination of the situation.

Optimum currency areas theoryA systematic way of trying to decide whether it makes sense for a goupe of countries to abandon their national currencies.

The real economic cost of giving up the exchange rate instrument arises in the presence of asymmetric shocks ie shocks that do not affect all currency union members.

MUNDELL CRITERION (Robert A. Mundell)

Labour mobility: OCA are those within which people move easily.

Factors of production, capital and labour, must be fully mobile across borders.Ex: country A undergoes unemployment while B faces inflationary pressures; both problems can be solved by a shift of idle production factors in A to B.

Europe is far from fulfilling this criterion.

KENEN CRITERION (Peter Kenen)

Product diversification: countries whose production and exports are widely diversified and of a similar structure form an OCA.

The countries most likely to be affected by severe shocks are those that specialize in the production of a narrow range of goods.

As far as this criterion is concerned, most EU countries qualify for joining a monetary union.

Mc KINNON CRITERION (Ronald Mc Kinon)

Openness: countries which are very open to trade and trade heavily with each other form an OCA.

Very open and medium size or little countries have no influence on world prices. Giving up the exchange rate does not entail much of a loss.

Europe qualifies.

TRANSFER CRITERION

Countries that agree to compensate each other for adverse shocks form an OCA.

Fiscal transfers of this kind exist across regions in every country. Some federal countries operate explicit transfer systems.

Europe does not qualify yet.

HOMOGENEITY OF PREFERENCES CRITERION

Currency union member countries must share a wide consensus on the way to deal with shocks.

Are we more concerned about inflation or unemployment?Should we favour the exporters or the consumers ?Unions, lobbiesPolitical consensus necessary.

This criterion is only partly fulfilled.

SOLIDARITY CRITERION vs.nationalism

When the common monetary policy gives rise to conflicts of national interests, the countries that form a currency area need to accept the costs in the name of a common destiny.

Europe qualifies partly.

Will europe come closer to an OCA ?Asymmetric shocks ? Do asymmetric shocks happen often enough, and are large enough, to be a serious concern ?

Openness (share of economic activity devoted to international trade? In a small open economy, most of the goods produced and consumed are traded on international markets. Their prices on local markets are largely independent of local conditions. Any change in the value of the currency tends to be passed into domestic prices. Exchange rate changes fail to affect the countrys competitiveness and are useless. Most European countries are very open, the more so the smaller they are. They are in favour of the monetary union.

Diversification and trade dissimilarity ? Asymmetric shocks are less likely among countries that share similar production patterns and whose trade is diversified. Countries the economy of which is far too integrated to afford exchange rate fluctuations whish to be deeply involved in European integration.

Labour mobility ? Less evident than in the US or Canada. Asymmetric shocks, when they occur, are likely to be met by unemployement in countries facing a loss of competitiveness.

Fiscal transfers ? Definitely not an OCA!

Homogeneous preferences ? There remains some heterogeneity. One reason why the inflation-prone countries have been eager to join the monetary union is that it provides for a degree of monetary policy discipline that has been elusive in the past.

Solidarity vs nationalism ? We progress.

Will europe become an OCA ?Effects of a currency union on trade ? Stable exchanges rates promote trade integration which enhances fulfiment of the McKinnon criterion.Effects of trade on specialization/diversification? - trade leads to more specialization as each country focuses on its comparative advantage.- trade leads to more diversification. Integration leads to intra-industry trade: exports and imports include similar goods. Every country produces the whole range of goods, simply with different brands, offering customers more choice. In the process, trade becomes more diversified.

Effects of a currency union on labour markets ? European labour mobility is low. Flexibility is an alternative ?

Fiscal transfers ? No political support.

Politics ?

18 Members of the eurozone1999: 11 MEMBERS:AUSTRIA, BELGIUM, FINLAND, FRANCE, GERMANY, IRELAND, ITALY, LUXEMBOURG, NETHERLANDS, PORTUGAL, SPAIN2001: GREECE2007: SLOVENIA2008: CYPRUS, MALTA2009: SLOVAKIA2011: ESTONIA2012: LETTONIA

MEMBERS OF THE EU NOT USING THE EURO10 MEMBER STATES: BULGARIA, THE CZECH REPUBLIC, DENMARK, HUNGARY, LATVIA, LITHUANIA, POLAND, ROMANIA, SWEDEN, UNITED KINGDOM.

OPT-OUT CLAUSE IN THE TREATY FOR DENMARK AND UK.

SWEDEN: DE FACTO OPT- OUT (HAS NOT JOINED THE ERM2).

THE EURO CRISIS .

The reasons of the crisis ?

The elements of a solution ?