Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 7 Open Economies Macroeconomics Monetary history of Europe Choice of Exchange Rate Systems Theory and Politics of Eropean Integration

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 –Simulation of labour market effects by skills

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Monetary Integration

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Monetary Integration: Overview I 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Monetary Integration: Overview 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe An Introduction to Open Economy Macroeconomics: Three basic principles 1Long term: neutrality of money and PPP 2Short term: non-neutrality of money, real and monetary matters interfere (cyclical fluctuations and shocks) 3Interest parity condition

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe The long-term neutrality of money: theory AD long-term AS short-term AS output gap inflation rate 0 The AS-AD model output gap (Actual – Trend GDP)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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) Aggregate Demand (AD): Why downward sloping? Inflation erodes purchasing power of money and discourages consumption (and investment). Hence, output is higher the lower inflation.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe The long-term neutrality of money: theory AD long-term AS short-term AS output gap Inflation rate 0 The AS-AD model output gap (Actual – Trend GDP) AS: Why upward sloping? Depression results in lower wages and lower prices of firm, while boom results in higher wage and price pressures

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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) 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 IS = Investment-Saving Curve (real sector) LM = Liquidity Preference-Money Supply Curve (monetary sector)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 5. Different implications under flexibel and fixed exchange rates

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 – but with a flexibel one!

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 economies! interest rate

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 Classic gold standard period Frequent financial crises, armed conflicts and depressions

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Understanding the Gold Standard: Hume’s mechanism

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Gold standard: The Global Monetary Union 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium gold money price level P1P1 M1M1 M0M0 A current account deficit current account surplus

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilbrium gold money price level P1P1 MM0M0 A current account deficit current account surplus Money determines the price level (in the long run) E

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium gold money price level P*P* MM0M0 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 E

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Neutrality of money and current account equilibrium gold money price level P*P* MM0M0 A current account deficit 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. E

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilibrium gold money 0 M E M0M0 A outflow of money inflow of money BoP

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Balance of payment equilibrium gold money 0 M EC M0M0 A outflow of money inflow of money BoP Hume’s mechanism: return to balance is automatic. If we start with a high money stock (e.g. point M 0 ), 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium gold money interest rate i* MM0M0 A financial account surplus financial account deficit E

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium gold money interest rate i* MM0M0 A financial account surplus financial account deficit E 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium gold money interest rate i* MM0M0 A financial account surplus financial account deficit E Thus, if i > i*, capital account is in surplus, and if i < i* it turns into a deficit Equilibrium is achieved if i = i*

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Financial account equilibrium gold money interest rate i* MM0M0 A financial account surplus financial account deficit E Relation between financial and current account: Capital inflow requires high interest rate and increases in 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 equilibrium since interest rates differ. 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 (in theory): 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Back to History

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 speculative attacks alsmost destroyed EMS, IT and UK left, realignments of IR, ESP, PT

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 exchange rates were irrevocably frozen, 2002 Euro notes and coins were circulatred

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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 be able to cope with shocks Partial- ly Yes Conductor existingYes Yes (largely) Yes

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Choice of Exchange Rate Regimes

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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, possible to realign (not in case of EMU)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe Fear of floating

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration A Monetary History of Europe NEXT LECTURE January 28 (sic!), 2016 Optimum Currency Areas The European Fiscal and Growth Pact