Theorie und Politik der Europäischen Integration Theory and Politics of Eropean Integration Lecture 6 Open Economies Macroeconomics Monetary History of Europe Choice of Exchange Rate Systems Prof. Dr. Herbert Brücker

Last Lecture Growth effects, capital and labour market integration Theory and Politics of European Integration A Monetary History of Europe Last Lecture Growth effects, capital and labour market integration Growth effects Static and dynamic effects of integration Static: allocation effects Neoclassical (Solow) growth model: temporary growth effects, in steady state higher income level Endogenous growth models: continuous growth effects via higher investment in physical and human (knowledge) capital which increases rate of technological progress Empirical evidence: higher transitional growth through integration Capital market integration Integration equalises capital endowments and interest rates Creates winners and loses in sending and receiving countries Aggregate income gain

Last Lecture Labour market integration Institutions Theory and Politics of European Integration A Monetary History of Europe Last Lecture Labour market integration Institutions Scale of migration and income differences Composition of migrants, self-selection and out-selection Labour market impact Standard model with perfect labour markets Equalisation of wage rates Aggregate gains, but winners and losers More complex models: Capital stock adjustment Wage rigidities and unemployment Empirical evidence

This lecture: Monetary Integration (I/II) Theory and Politics of European Integration A Monetary History of Europe This lecture: Monetary Integration (I/II) An Introduction to Open Economies Macroeconomics The long-term neutrality of money: theory The short-term non-neutrality of money The IS-LM diagram Exchange rate and fiscal policies and exchange rate ragimes A monetary history of Europe Metallic money The gold standard The interwar period The post-war period: from Bretton Woods to EMU

This lecture: Monetary Integration (II/II) Theory and Politics of European Integration A Monetary History of Europe This lecture: Monetary Integration (II/II) Choice of an exchange rate regime Exchange rate and monetary policy The range of exchange rate policies Choices Criteria Fix or float? Regional arrangements

An Introduction to Open Economy Macroeconomics: Three basic principles Theory and Politics of European Integration A Monetary History of Europe An Introduction to Open Economy Macroeconomics: Three basic principles 1 Long term: neutrality of money and PPP 2 Short term: non-neutrality of money, real and monetary matters interfere (cyclical fluctuations and shocks) 3 Interest parity condition

The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe The long-term neutrality of money: theory short-term AS long-term AS inflation rate AD AD AD: Why downward sloping? Inflation erodes purchasing power of money and discourages consumption and investment C B A output gap The AS-AD model output gap (Actual – Trend GDP)

The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe The long-term neutrality of money: theory short-term AS long-term AS Inflation rate AD AD AS: Why upward sloping? Depression results in lower wages and lower prices of firm, while boom results in higher wage and price pressures C B A output gap The AS-AD model output gap (Actual – Trend GDP)

The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe The long-term neutrality of money: theory short-term AS long-term AS Inflation rate AD AD Long-run: If prices rise faster than wages, purchasing power declines, creates wage pressure, eventually we move back to long-run wage-price relation at C. C B A output gap The AS-AD model output gap (Actual – Trend GDP)

Long term neutrality implication: PPP 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 = domestic price; P* = foreign 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

Short term non-neutrality of money 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

Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model interest rate LM LM‘ foreign level A D IS‘ C B IS Output-gap (Actual-Trend GDP)

Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model interest rate LM LM‘ 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 Foreign level A D IS‘ C B IS Output-gap (Actual-Trend GDP)

Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model interest rate LM LM‘ Flexible exchange rate: currency depreciates current account improves (IS shifts to IS‘) output moves eventually to D Foreign level A D IS‘ C B IS Output-gap (Actual-Trend GDP)

Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model interest rate LM LM‘ 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 Foreign level A D IS‘ C B IS output-gap (Actual-Trend GDP)

Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Monetary policy in the IS-LM model interest rate LM LM‘ Thus, there is no room for monetary policy with a fixed exchange rate! Foreign level A D IS‘ C B IS output-gap (Actual-Trend GDP)

Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model interest rate LM LM‘ B Foreign level A C IS‘ IS Output-gap (Actual-Trend GDP)

Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model interest rate LM LM‘ B Foreign level A C IS‘ Fiscal policy shifts IS curve to IS’. LM stays where it is. Output moves to B. The interest rate rises above foreign level. Capital flows in to restore interest parity IS Output-gap (Actual-Trend GDP)

Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model interest rate LM LM‘ B Foreign level A C IS‘ 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 IS Output-gap (Actual-Trend GDP)

Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model interest rate LM LM‘ B Foreign level A C IS‘ IS 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 Output-gap (Actual-Trend GDP)

Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe Fiscal policy in the IS-LM model interest rate LM LM‘ Thus, fiscal policy does only work under fixed exchange rates in small open economies B Foreign level A C IS‘ IS Output-gap (Actual-Trend GDP)

Exchange rate regimes and policy effectiveness Theory and Politics of European Integration A Monetary History of Europe Exchange rate regimes and policy effectiveness Monetary policy Fiscal policy Fixed exchange rate Ineffective Effective Flexible exchange rate

When does the regime matter? 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 and wages are sticky

A Monetary History of Europe Theory and Politics of European Integration A Monetary History of Europe 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.

Seignorage as key source of public finance 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

Metallic Money: Some Details Theory and Politics of European Integration A Monetary History of Europe Metallic Money: Some Details From 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

Gold standard: The Global Monetary Union Theory and Politics of European Integration A Monetary History of Europe Gold standard: The Global Monetary Union 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 or macroeconomic principles long-run neutrality of money rate of inflation is driven by rate of money growth effect of money on interest rates Helps to understand working of EMU

Neutrality of money and current account equilibrium Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium price level A current account deficit P1 current account surplus M1 M0 gold money

Neutrality of money and current account equilbrium Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilbrium Money determines the price level (in the long run) price level A E current account deficit P1 current account surplus M M0 gold money

Neutrality of money and current account equilibrium Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium price level A E current account deficit P* 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 M M0 gold money

Neutrality of money and current account equilibrium Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium price level A E current account deficit P* current account surplus If we have a Current Account deficit, money flows out and the money stocks contract. Eventually, equilibrium is achieved where the domestic price level equals the international. The Current Account is balanced. M M0 gold money

Balance of payment equilibrium Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilibrium BoP E M0 gold money M A inflow of money outflow of money

Balance of payment equilibrium Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilibrium Hume’s mechanism: return to balance is automatic. If we start with a high money stock (e.g. point M0), domestic prices are high, balance of payments turns in deficit and gold flows out, but commodities in (current account surplus) Why? We have to buy other goods by gold. Converse holds for low money stock in initial situation. BoP C E M0 gold money M A inflow of money outflow of money

Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium interest rate A E financial account surplus i* financial account deficit M0 M gold money

Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium interest rate A E financial account surplus i* financial account deficit So far we have ignored financial sector. Capital flows allow in short-term deviation from long-term equilbrium. if the stock of money increases, the domestic interest rate declines if the interest rate is below the international rate i*, it pays to borrow gold at home and ship it abroad, i.e. capital flows out M0 M gold money

Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium interest rate A E financial account surplus i* financial account deficit Thus, if i > i*, capital account is in surplus, and if i < i* it turns into a deficit Equilibrium is achieved if i = i* M0 M gold money

Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium interest rate A E financial account surplus i* financial account deficit Relation between financial and current account: Capital inflow requires high interest rate and increases prices Both capital and current account deteriorate Trade route is slower, but both work in same direction In the long-term, capital flows equalise interest rates, current account adjusts, such that the current account, capital balance and BoP is in equilibrium. M0 M gold money

Monetary equilibrium under gold standard Theory and Politics of European Integration A Monetary History of Europe Monetary equilibrium under gold standard Summing up: Money in excess of M translates into balance of payment deficits and gold outflows If money is in short supply (left of E = M), 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 This forms however only a short-term equilbrium. Thus, the gold standard results in a balance of payments equilibrium in the short-run, and a current account and capital account equilibrium in the long-run where domestic interest rates and prices equal the international ones.

Monetary equilibrium under gold standard 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)

Rules of the game and problems 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

Similarities to the EMU Theory and Politics of European Integration A Monetary History of Europe Similarities to the EMU EURO replaces gold (no national money supply) Hume’s mechanism works in Eurozone: 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

The interwar period: the worst of all worlds Theory and Politics of European Integration A Monetary History of Europe The interwar period: the worst of all worlds Shipping gold became too dangerous and 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

The interwar period: three case studies 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%. Cost: decade of miserable growth.  ·  The French case: high debts hoping for German’s reparations, inflation soared after reparations failed. Return to gold standard and devaluation in 1928; undervaluation and beggar-your-neighbour policies protected economy first, but then others retaliate and the currency becomes overvalued, badly hit by Great Depression. The German case: hyperinflation, gold standard no option (reparations), 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 under Nazi government.

· We need a system, one way or another 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 exchange rate misalignments, competitive devaluations and trade wars Domestic misbehaviour undermine fixed exchange rates such as gold standard Exchange rate agreements require “rules of the game”, including a conductor, e.g. city of London before WW I

European post-war arrangements Theory and Politics of European Integration A Monetary History of Europe European post-war 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 European Monetary Union 

European postwar arrangements (cont.) 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 (devaluation of 10 %) Collapse 1973 The Snake arrangement Agreeing on stabilizing intra-European bilateral parities No enforcement mechanism: too fragile to survive Diverging inflation rates across European countries 

Theory and Politics of European Integration 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 But, still inflation divergence and misalignments kept growing 1992-93 speculative attacks alsmost destroyed EMS, IT and UK left, realignments of IR, ESP, PT

· EMS de facto doomed From EMS to EMU (EURO) Theory and Politics of European Integration A Monetary History of Europe From EMS to EMU (EURO) ·  EMS de facto doomed Convergence to Bundesbank standards means that all other countries lost monetary independence Delors report prepared European Monetary and Financial Union, plan for common currency EMU plan adopted at Maastricht Summit 1989 1999 exchange rates were irrevocably frozen, 2002 Euro notes and coins were circulatred

Lessons from history Gold standard Inter- war Bretton Woods EMS EMU Theory and Politics of European Integration A Monetary History of Europe Lessons from history Gold standard Inter- war Bretton Woods EMS EMU Long-lasting misalignments must be avoided Yes (auto-matic) Yes (not pos-sible) Systems need to be built coherently Policy misbehaviour is ruled out (largely) Systems must able to cope with shocks Conductor existing

The choice of an exchange rate regime 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: fixed or flexible? 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

Free floating (e.g. US, Eurozone) Managed floating (e.g. Japan) 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 +-1%) Currency boards (e.g. Estonia, Lithuania in 1990s) Dollarization/Euroization Monetary union

The choice of an exchange rate regime 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

The old debate: fixed vs. float 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

The new debate: the two-corners solution 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 undervaluations 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

The two-corners solution and the real world 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

Theory and Politics of European Integration Theory and Politics of European Integration A Monetary History of Europe Fear of floating

The two-corners solution and the real world 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

A menu hard to pick from: trade-offs are everywhere 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

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