Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 11 A Monetary History of Europe and the Choice of Exchange Rate Systems.

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1 Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 11 A Monetary History of Europe and the Choice of Exchange Rate Systems Theory and Politics of Eropean Integration

2 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Last Lecture EU Regional and Agricultural Policies

3 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe This lecture A monetary history of Europe Metallic money The gold standard The interwar period The post-war period: from Bretton Woods to EMU Choice of an exchange rate regime Exchange rate and monetary policy The range of exchange rate policies Choices ·Criteria ·Fix or float? ·Regional arrangements

4 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Why studying history? Monetary union is the controversial end of a long process. History helps understand. Since paper money was invented, Europe’s monetary history carries important lessons. Particularly the bad ones. Before paper money, Europe was a de facto monetary union. Understand how it worked helps understand how the new union (EMU) works.

5 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Metallic Money Under metallic money (overlooking the difference between gold and silver) the whole world was really a monetary union Seignorage as key source of public finance ·‘shaving’ as a means to generate revenues Multiplicity of money Previous explicit unions only agreed on the metal content of coins to simplify everyday trading

6 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Metallic Money: Some Details F rom immemorial until 19th century metallic money (gold or silver) dominant means of payment Bimetallism (gold and silver) with fluctuating exchange rates depending on discoveries Monetary unions as a tool of nation-building e.g. Germany: before 1871 different monetary standards Two historical monetary unions Latin Monetary Union (BE, FR, IT) to preserve bimetallism Scandinavian Monetary Union ceased at WWI

7 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Gold standard Classic gold standard period 1880-1914 Frequent financial crises, armed conflicts and depressions Working of the gold standard: Hume’s “price-specie- mechanism” (“specie” = money/gold) Key assumptions long-run neutrality of money effect of money on interest rates Helps to understand working of EMU

8 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium gold money price level P*P* M1M1 M0M0 A current account deficit current account surplus

9 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilbrium gold money price level P*P* M1M1 M0M0 A current account deficit current account surplus Money determines the price level (in the long run)

10 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilbrium gold money price level P*P* M1M1 M0M0 A current account deficit current account surplus Price level affects the trade balance If domestic prices are high relative to foreign prices, we have a deficit Conversely, relatively low domestic prices lead to a trade surplus

11 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilbrium gold money price level P*P* M1M1 M0M0 A current account deficit current account surplus Trade balance is achieved when the stock of money is M 1, and, hence, domestic prices equal P*.

12 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilibrium gold money 0 M0M0 A C B‘ B outflow of money inflow of money

13 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilbrium gold money 0 M0M0 A C B‘ B outflow of money inflow of money Hume’s mechanism: return to balance is automatic. If we start with a high money stock (e.g. point B), balance of payments turns in deficit and gold flows out, but commodities in (current account surplus) Why? We have to buy gold by other goods.

14 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilbrium gold money 0 M0M0 A C B‘ B outflow of money inflow of money If we start with a low money stock (e.g. point C), balance of payments turns in surplus and gold flows in, but commodities out (current account deficit)

15 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium gold money interest rate i* M2M2 M0M0 A financial account surplus financial account deficit

16 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium gold money interest rate i* M2M2 M0M0 A financial account surplus financial account deficit Much the same story applies to the financial account: if the domestic interest rate is high (low), capital flows in (out) and the return to balance is automatic

17 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary equilibrium under gold standard Money in excess of M 0 translates into balance of payment deficits and gold outflows If money is in short supply (left of A = M 0 ), balance of payments is in surplus and gold flows in Point A may correspond to a point with imbalances in current and capital account, e.g. a point where the current account deficit exactly matches the capital account surplus Thus, the gold standard results in a balance of payments equilibrium, but not (necessarily) a current account or capital account equilibrium

18 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary equilibrium under gold standard Financial markets support equilibrium: if money supply declines, interest rate increases, which attracts capital Over time, if a country is in short supply of gold money supply stringency creates increasing interest rates, growth slow-down, higher unemployment and a downward pressure on prices and wages All markets contribute to eliminate external imbalance, no need for government intervention (in theory)

19 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Rules of the game and problems Full gold convertibility at fixed price of all banknotes Full backing. Central Bank holds same amount of gold as notes issued Complete freedom of trade and capital mobility Problems: Sticky prices and wages (short-term disequilibria) World money supply driven by discoveries and money demand driven by economic growth go not hand in hand Governments facing deficits tend to opt out of gold standard

20 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Similarities to the EMU EURO replaces gold (no national money supply) Balance of payments surplus translates into EURO inflows Balance of payments deficit translates into EURO outflows Exchange rate cannot be used to equilibrate external deficits Adjustment has to work via prices and wages

21 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The interwar period: the worst of all worlds Paper money starts circulating widely Yet the authorities attempt to carry on with the gold standard but: No agreement on how to set exchange rates between paper monies An imbalanced starting point with war legacies ·High inflation ·High public debts

22 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The interwar period: three case studies  The British case: return to gold standard pre-war parity and refusal to devalue an overvalued currency relative to US breeds economic decline. Abolished unsustainable gold standard in 1931 and devalued currency by 30%.  The French case: return to gold standard and devaluation in 1928; undervaluation and beggar-your-neighbour policies, until others retaliate and the currency becomes overvalued, badly hit by Great Depression The German case: hyperinflation, gold standard no option, devaluation and anti-inflation policy in 1924, turns into overvaluation in the early 1930s, and, finally, evading the choice of an appropriate exchange rate by resorting to ever-widening non-market controls

23 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Lessons so far  We need a system, one way or another The gold standard – monetary unions – delivers automatic return to equilibrium, but at the cost of booms and recessions No agreement leads to misalignments, competitive devaluations and trade wars Agreements require “rules of the game”, including a conductor

24 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe European postwar arrangements  An overriding desire for exchange rate stability Initially provided by the Bretton Woods system The US dollar as anchor and the IMF as conductor Gold convertibility of US-$: 35 US-$ per ounce Once Bretton Woods collapsed, the Europeans were left on their own The timid Snake arrangement The European Monetary System The monetary union

25 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe European postwar arrangements (cont.)  The Bretton Wood collapse Financing the Vietnam war by public debt which fueled inflation and created large current account deficits Diverging inflation rates and real appreciation pressures of many currencies (e.g. DM) Suspension of gold convertibility and realignment 1971 Collapse 1973 The Snake arrangement Agreeing on stabilizing intra-European bilateral parities No enforcement mechanism: too fragile to survive

26 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The EMS: Super Snake  Complements bilateral exchange rate commitments with a support mechanism Allows for prompt realignments to avoid misalignments Emergence of the DM as the system’s anchor

27 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Lessons from history Gold standard Inter- war Bretton Woods EMSEMU Long-lasting misalignments must be avoided Yes (auto- matic) Yes (not pos- sible) Systems need to be built coherently Yes Policy misbehaviour is ruled out (largely)Yes Systems must able to cope with shocks Yes Conductor existingYes

28 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The choice of an exchange rate regime An question and the answer The question: what to do with the exchange rates Viewpoint of an individual country, in contrast to systems Underlines the principles to evaluate the merits of a monetary union The answer: there is no best arrangement A matter of trade-offs

29 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Three basic principles 1Long term: neutrality of money 2Short term: non-neutrality of money 3Interest parity condition

30 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The long-term neutrality of money: theory A B C AD long-term AS short-term AS output gap Inflation rate 0 The AS-AD model output gap (Actual – Trend GDP)

31 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Long term neutrality implication: PPP The real exchange rate Defined as = EP/P* E = nominal exchange rate; P = domnestic price; P* = foeign price Purchasing Power Parity (PPP): E offsets changes in P/P* So is constant Many caveats, though: PPP seems to hold in the long run, but not in the short and medium run

32 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Short term non-neutrality of money From AD-AS: the short-run AS schedule So monetary policy matters in the short run Channels of monetary policy The interest rate channel The credit channel The stock market channel The exchange rate channel

33 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) foreign level interest rate

34 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level interest rate 1. increase in money supply moves LM to LM‘, 2. interst rates declines initially to B, 3. spending expands and economy moves to C 4. capital flows out until interest rate is back to international level

35 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level interest rate Flexible exchange rate: currency depreciates current account improves (IS shifts to IS‘) output moves eventually to D

36 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ output-gap (Actual-Trend GDP) Foreign level interest rate Fixed exchange rate: Central Bank must intervene in exchange market money supply shrinks until LM curve shifts back from LM‘ to LM and output to A

37 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ output-gap (Actual-Trend GDP) Foreign level interest rate Thus, there is no room for monetary policy with a fixed exchange rate!

38 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level interest rate

39 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level 1.Fiscal policy shifts IS curve to IS’. 2.LM stays where it is. 3.Output moves to B. 4.The interest rate rises above foreign level. 5.Capital flows in to restore interest parity interest rate

40 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Fixed exchange rate: Central Bank intervenes to prevent currency appreciation sells money such that increased money supply shifts LM to LM’ economy moves eventually to point C interest rate

41 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Flexible exchange rate: Capital flows in and currency appreciates Current account worsens Demand declines Eventually, IS’ shifts back to IS and the economy back to A interest rate

42 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Thus, fiscal policy does only work under fixed exchange rates in small open economnies interest rate

43 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Exchange rate regimes and policy effectiveness Monetary policy Fiscal policy Fixed exchange rate IneffectiveEffective Flexible exchange rate EffectiveIneffective

44 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe When does the regime matter? In the short run, changes in E are mirrored in changes in = EP/P*: P and P* are sticky In the long run, is independent of E: P adjusts If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy Put differently, the choice of an exchange rate regime has mostly short run effects because prices are sticky

45 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe What’s on the menu? Free floating (e.g. US, Eurozone) Managed floating (e.g. Japan) Target zones (e.g. ‘snake’) Crawling pegs (e.g. Poland under transition) Fixed and adjustable (e.g. Bretton Woods) Currency boards (e.g. Estonia, Lithuania in 1990s) Dollarization/Euroization Monetary union

46 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The choice of an exchange rate regime The monetary policy instrument Can be useful to deal with cyclical disturbances Can be misused (inflation) The fiscal policy instrument Can also deal with cycles but is often politicized Can be misused (public debts, political cycles) Exchange rate stability Freely floating exchange rates move “too much” Fixed exchange rates eventually become misaligned

47 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The old debate: fixed vs. float The case for flexible rates With sticky prices, need exchange rate flexibility to deal with shocks Remove the exchange rate from politicization Monetary policy is too useful to be jettisoned The case for fixed rates Flexible rates move too much (financial markets are often hectic) Exchange rate volatility: a source of uncertainty A way of disciplining monetary policy In presence of shocks, always possible to realign

48 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The new debate: the two-corners solution Only pure floats or hard pegs are robust Intermediate arrangements (soft pegs) invite government manipulations, over or under valuations and speculative attacks Pure floats remove the exchange rate from the policy domain Hard pegs are unassailable (well, until Argentina’s currency board collapsed…) In line with theory Soft pegs are half-hearted monetary policy commitments, so they ultimately fail

49 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The two-corners solution and the real world Fear of floating Many countries officially float but in fact intervene quite a bit Fear of fixing Many countries declare a peg but let the exchange rate move out of official bounds

50 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Fear of floating

51 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe The two-corners solution and the real world Fear of floating is deeply ingrained in many European countries Fear of fixing partly explains the disenchantment with the EMS and some reluctance towards monetary union

52 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe Conclusions A menu hard to pick from: trade-offs are everywhere All of this takes the view from a single country Systems involve many countries and rest on agreed upon rules, including mutual support Since the end of Bretton Woods, there is no world monetary system This leaves room for regional monetary systems. Enters Europe’s experience

53 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration A Monetary History of Europe NEXT LECTURE Optimum Currency Areas Reading: Baldwin/Wyplosz (2006, Ch. 16)