reinert/windows on the world economy, 2005 monetary unions chapter 18

Reinert/Windows on the World Economy, 2005

Monetary Unions

CHAPTER 18


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Introduction

Options for the exchange rate regime of a country include Flexible exchange rate (a “clean” or “dirty” float)

• However, country might be buffeted by destabilizing changes in nominal (and hence real) exchange rate

Fixed exchange rate (or crawling peg)• However, country might eventually stumble into a balance of payments

crisis All countries in the RTA could agree to do away with all the

exchange rates by becoming a monetary union with a common currency

• Would still need to decide upon exchange rate regime for common currency

But can avoid exchange rate instability with major trade and investment partners

Policy has been adopted by countries of Western Europe and a group of African countries with ties to France


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Planning the European Monetary Union

History of monetary integration in Europe goes back to the immediate post-World War II period

Initiative began in 1970 when a commission issued report providing detailed plan for step-by-step movement to European Monetary Union by 1980

European Council of Ministers of Economics and Finance (ECOFIN) endorsed Werner Report in March 1971

Unfortunately subsequent months brought on demise of the Bretton Woods system of global monetary arrangements In response to this crisis members of European Common Market

decide to bind their exchange rates within 2.25% of each other• Known as “snake in a tunnel” or “snake” which continued through 1978


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Table 18.1. The Evolution of the European Union


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In October 1977, European Commission President Roy Jenkins called for Europe to adopt monetary union

In 1978, negotiations began in earnest over the creation of a European Monetary System Came into being as a fixed-rate system in March 1979 Was an attempt to replicate fixed-rate Bretton Woods

system among countries of Europe European Currency Unit or ECU was created

• Role equivalent to that initially hoped for SDR in the Bretton Woods system


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Original hope was that each country would peg their currency to ECU Instead, in 1980s countries began to peg their

currencies to German mark ECU continued only as a unit of account for

official European Community business Great deal of instability in the early years of the

ECU


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In April 1989 President of the European Commission, Jacques Delors, issued a report Called for a single currency and an integrated

system of European central banks Maastricht Treaty, agreed to in December 1991,

was to serve as a constitution of new European Union, replacing Treaty of Rome• Set 1999 as a target date for a European Monetary

Union or EMU


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European Monetary Institute

In 1994 a European Monetary Institute (EMI) came into being with the purpose of Planning for future European System of Central

Banks or ESCB Plot course towards monetary integration Monitoring progress of member countries toward

meeting a set of convergence criteria• Concerning price stability, levels of government

deficits and debt, exchange rate targets, and interest rate targets


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Evolution Towards EMU

Proved to be more difficult than envisioned in the Delors report

In 1990, East and West Germany had reunified Required unprecedented increases in public expenditure on part of

German government To prevent German economy from expanding too quickly, central

bank pursued a tight or restrictive monetary policy• Kept German interest rate high, caused international investors to favor

mark-denominated assets over other European assets, and put downward pressure on value of other European currencies

• EMS par-value system came under pressure• Difficulties in ratification of 1992 Maastricht Treaty ruffled investors’

expectations Growing predictions of a “no” vote (proved to be incorrect) in French

referendum on Maastricht in September 1992 Other currencies values were also forced outside of EMS

• In response, margins around parities were expanded from 2.25% to 15%


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Evolution Towards EMU

British government subsequently opted out of EMU

However, most EU leaders pressed on Committed themselves to introducing a common

currency, called the euro Adopted EMI’s plan for monetary integration

despite widespread misgivings


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Implementing the European Monetary Union

In 1997 European Union adopted Stability and Growth Pact Places restrictions on EMU member countries’ fiscal

policies In 1998, EU leaders determined countries which were to

take part in the EMU/euro• Austria, Belgium, Finland, France, Germany, Ireland, Italy,

Luxembourg, the Netherlands, Portugal, and Spain Reflected extent to which countries met the convergence criteria

• Greece wanted to join but was not allowed to—decision was later reversed


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European System of Central Banks

Centerpiece of EMU European Central Bank (ECB) Former national central banks in a structure modeled

quite closely on Federal Reserve System of United States

Primary goal is conduct of monetary policy to maintain of price stability within EMU

Required to maintain annual increases in a Harmonized Index of Consumer Prices (HICP) at or below 2%

• Widely regarded as a very stringent rule, but one insisted upon by German central bank


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European Central Bank

Headed by a President with an eight-year, non-renewable term

European Council appoints ECB President, and a battle ensued over who would fill this post

Executive Board is composed of Vice President and four other individuals Responsible for implementing monetary policy within EMU

Executive Board and other heads of EMU member central banks compose ECB Governing Council Governing Council is responsible for formulating monetary policy

within EMU General Council that adds the 4 heads of EU member central banks

that are not part of EMU• Administrative body that is responsible for work previously undertaken

by EMI


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Figure 18.1. Organizational Structure of the ECB


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The Euro

Launched in January 1999 EMU member exchange rates became “irrevocably” locked Monetary policy was transferred to ECB

Capitalized at 5,000 million euros with subscriptions from central banks of all EU countries

Value initially set at $1.186 in a flexible exchange rate regime By June 1999, value had fallen to nearly $1.00

• Reflects the flexible exchange rate regime

In January 2002, ECB introduced euro notes and coins Began process of withdrawing old notes and coins from circulation


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Figure 18.2. The Dollar Value of the Euro, 1999 to 2002


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Optimum Currency Areas and Adjustment in the EMU

Optimum currency area is a collection of countries characterized by Well-integrated factor markets Well-integrated fiscal systems Economic disturbances that affect each country in a

symmetrical manner• For example United States constitutes an optimum currency area

Labor and physical capital are mobile among the states Great deal of integration of fiscal systems through federal

government Cycles of recession and recovery tend to affect each region in a

somewhat symmetrical manner


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Optimum Currency Areas and Adjustment in the EMU

Seems to be less evidence that EMU is an optimum currency area Both labor and physical capital are less mobile

than in United States Budget is relatively small in proportion to size of

the economies involved Business cycles among members of the EMU

are somewhat asymmetrical


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Adjustment in the EMU

The absence of an optimum currency area is troublesome In a face of a recession in one country, unemployment will rise

• Rise in unemployment can be addressed in four ways An overall decline in wage rates leading to increases in quantity demanded

for labor Can in principle address unemployment problems However, wages in most EMU countries are notoriously “downward

inflexible” Labor mobility out of areas of unemployment

Could likewise help achieve adjustment; however labor mobility within EMU is not very strong

Expansionary monetary policy (at EU level) However, ECB is required to maintain annual increases in a

Harmonized Index of Consumer Prices at or below 2% Expansionary fiscal policies (at member country level)

However, under EU’s Growth and Stability Pact, convergence criteria have evolved into rules setting limits to fiscal policy of member countries


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The CFA Franc Zone

A complete and functioning monetary union among 13 member countries Have adopted CFA franc as a common currency In existence since 1945

Economic performance (until mid 1980s) was no worse than and perhaps better than neighboring countries with floating or managed floating exchange rates

Central Bank for West African States and Bank for Central African States maintain a foreign exchange reserve pool Keep 65% of their reserves with French Treasury


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The CFA Franc Zone

Fixed peg to French franc Strategy worked up to mid-1980s

• World prices of main CFA export goods declined significantly

• Countries involved found themselves in balance of payments difficulties

• Devaluation was not a possibility and adjustment was attempted by contractionary macroeconomic policies

Aimed at reducing import demands and maintaining high interest rates

• Some CFA members began to turn to IMF for assistance

• Devaluation of 50% against French franc was made in January 1994


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The CFA Franc Zone

With launch of euro in 1999, franc peg became a euro peg Makes some economic sense since EU is CFA franc

zone’s main trading partner Key question: Can CFA franc-euro peg be maintained?

Important lesson A monetary union, despite resolving exchange rate

difficulties among its members, still can involve difficulties in relationship of common currency with rest of the world

reinert/windows on the world economy, 2005 monetary unions chapter 18

Documents

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european unionplanning

monetary unionschapter

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exchange rate targets