Chapter 6: The Fragility of Incomplete Monetary Unions

1. Chapter 6:The Fragility of Incomplete Monetary Unions De Grauwe: Economics of Monetary Union

2. Incomplete monetary unions • Incomplete monetary unions are arrangements whereby the monetary authorities peg their exchange rates • Examples: the Bretton-Woods system and the ERM • Over time most of these arrangements tend to disintegrate after some crisis: • The Bretton-Woods system collapsed in 1973 • The exchange rate mechanism (ERM) of the EMS collapsed in 1993 • The South-East Asian currencies were hit by speculative attacks in 1997-98 • Similar crises involved Latin American currencies in the 1990s

3. Why are pegged exchange rate regimes to so fragile? • The fragility of a fixed exchange rate system has everything to do with credibility • When the authorities announce a fixed exchange rate they are making promise to keep the exchange rate fixed today and in the future • The problem with any promise is that doubts may arise as to whether it will be kept

4. Circumstances may arise in which the fixed exchange rate arrangement ceases to be seen as consistent with the economic welfare of the country • In that case the monetary authority will have an incentive to renege on its promise • Economic agents will suspect this and will attack the currency • A speculative crisis arises

5. Differences in reputation lead to low credibility of a fixed exchange rate • Barro - Gordon model is our framework for analysing problems of reputation

6. Fixing exchange rate is not credible Germany Italy E G B C F A UI UG Fixing the exchange rate of the lira with the mark is not credible, because Italian authorities have an incentive to create surprise inflation (devaluation)

7. In this model the high-inflation country (Italy) has a lot to gain from pegging its currency to the currency of the low-inflation country. It is borrowing reputation • Italy will find it difficult to fix its exchange rate credibly • The Italian authorities have an incentive to cheat (a temptation) so as to reduce unemployment

8. This temptation is larger the steeper is the indifference curve (see previous figure), i.e. the greater the weight the authorities attach to stabilizing employment (or output), a domestic objective • The weight the central bank attaches to this domestic objective is represented by 

9. Relation between the temptation of the central bank to devalue and the parameter  • Temptation, , = the benefit for the authorities of devaluing, given that agents expect that the central bank will never renege on its promise. • When >0 the central bank is tempted to devalue • This temptation increases with  • This regime in which the central bank fixes the exchange rate and then gives a non-zero weight to a domestic objective will not be credible • Rational agents will test the central bank and attack its stock of international reserves • Since most central banks give some non-zero weight to domestic objectives, fixing the exchange rate will most of the time not be credible (except if =0) temptation 

10. Fixed exchange rates are credible if cost of devaluation is high • It is possible for the central bank to combine fixed exchange rates and credibility only if devaluation is costly • The cost is a loss of reputation • By assumption this cost is fixed ( C0) • As long as < 0 the fixed exchange rate can be made credible, because the cost of loosing reputation exceeds the temptation to devalue • Will this hold in all states of nature?

11. Temptation curve, , as a function of the size of the shock, . •  is a shock in the Phillips curve • When >0 Phillips curve shifts upwards, creating unemployment • The temptation to devalue increases with the size of the shock (upward sloping), for any given  • As the shock becomes larger the cost in terms of lost employment (or output) increases increasing temptation • When the shock is zero (=0) temptation is 1 • If this is smaller than C0, the fixed exchange is credible • When > 0 temptation exceeds cost of devaluation; fixed rate looses credibility

12. ‘First generation’ models (Krugman (1979)) • As time goes by, the probability that some shock will exceed 0 is positive • A sufficiently large shock will make the fixed exchange rate non-credible • Only if the central bank can make it clear that it does not pursue any domestic objectives (=0) can this problem be avoided • Thus a crisis is inevitable if the central bank pursues domestic objectives that conflict with exchange rate commitment

13. ‘Second generation’ models (Obstfeld (1995)) • This model stresses that a country that attaches a low weight to domestic objectives and thus has a credible fixed exchange rate can still get into trouble • Assume that for some reason speculators expect the currency to be devalued • The authorities who want to maintain the fixed exchange rate will have to defend it against these speculators • Such a defence is costly • The central bank will be tempted to abandon the peg

14. We derive a second temptation curve () • This is the temptation to devalue when the authorities face expectations that a devaluation will occur •  increases with , i.e. the more the authorities care about domestic objectives the greater is the cost of defence and thus temptation temptation  

15. Temptation curve  is located above the temptation curve  • This is due to an asymmetry • The welfare loss from applying deflationary policies to defend the peg in the face of a speculative attack is greater than the welfare gain obtained from the expansionary employment effects of surprise devaluation

16. Assume =1 • There are two possible expectations: • A) Speculators do not expect a devaluation • The temptation of the central bank to devalue, ,is lower than the cost of a devaluation • The central bank has no incentive to devalue • B) Speculators expect a devaluation • The relevant temptation curve is  • The temptation to devalue is larger than the cost of a devaluation • The central bank has an incentive to devalue Temptation, Cost of defence Δ Θ C0 β1 β

17. There are therefore two possible equilibria that depend solely on the state of expectations • When agents do not expect a devaluation the authorities have no incentive to devalue so that the exchange rate remains fixed • When speculators expect a devaluation, the ensuing speculative attack creates an incentive for the authorities to devalue, and there will be a devaluation • In both cases expectations are model-consistent (rational)

18. Whether or not crises occur depends on combinations of  and C • Three situations can occur: • When  is low and C is high, we are in the no attack zone • When  is high and C is low we are in the attack zone • There is an intermediate zone (indeterminacy zone) where the cost of devaluation is intermediate between the two temptation curves

19. Policy Issue arising from greater capital mobility • When capital mobility increases: • the temptation curve  shifts upwards (from  to ’) • Indeterminacy zone increases • Fixed exchange rate becomes more fragile • Choice between more flexibility or tighter discipline on fixed rates • To keep the economy within the no attack zone: • 1)Increase the cost of devaluation from C0 to C1 • Example: Maastricht fixed exchange rate condition as entry requirement for EMU • 2) Reduce the weight for domestic objectives Temptation, Cost of defence Δ’ Δ Θ C1 C0 β

20. The n-1 problem in pegged exchange rate systems • In a system of n countries, there are only n - 1 independent exchange rates • Implications • n - 1 monetary authorities have to adjust their monetary policy instrument so as to maintain a fixed exchange rate • One monetary authority is free to set its monetary policy independently • Who will be the central bank that uses this degree of freedom? • Potential for conflict

21. Two-country model of the money markets • Country A • money demand: MAD = PALA( YA , rA) • money supply: MSA = RA+ DA • PA price level of country A, YA output, rA, interest rate , RA international reserves, DA credit to the domestic sector • Country B • money demand: MBD = PBLB( YB , rB) • money supply: MSB = RB+ DB

22. We assume perfect mobility of capital • The (open) interest parity condition holds • rA = rB +  •  is the expected rate of depreciation of the currency of country A. • In a fully credible fixed exchange rate system: = 0.

23. The n-1 problem in a two-country monetary model rA rB Country A Country B G H r2 E F r1 PBLB PALA M2A M1A M2B M1B MA MB • money demand downward-sloping curves • money supply M1A M1B • money market equilibrium where demand and supply intersect (points E and F). • the interest parity condition holds

24. Infinitely many combinations will satisfy the equilibrium conditions • Each of these combinations will produce one level of the interest rate and one of the money stocks • The fixed exchange rate arrangement is compatible with any possible level of the interest rates and of the money stocks • There is a fundamental indeterminacy in this system

25. How can the indeterminacy be solved? • Two possible solutions: • The asymmetric (hegemonic) solution • One country to take a leadership role by anchoring the money stock for the entire system • Example: Country A is leader and chooses point G; then country B has to take point H • The symmetric (co-operative) solution • Countries decide jointly about the level of their money stocks and interest rates

26. The mechanics of interventions in the foreign exchange market are different in the symmetric and asymmetric system • We illustrate this when a speculative crisis erupts

27. Intervention in a symmetric system • Currency B is expected to devalue • Speculators sell currency B against currency A • Central bank B buys its own currency and sells currency A • Country B’s money stock declines and country A’s money stock increases Country B Country A rA rB r3 r’2 r1 r2 M3B M1B M1A M2A MA M2B MB

28. Asymmetric intervention • Country B does all the adjustment • Money stock declines to M3B • Interest rate increases to r3 • Country A keeps money stock and interest rate unchanged (using sterilization policies) • The Bretton-Woods system and the EMS were asymmetric • When a speculative crisis arose, the leading-currency country (the US in the Bretton Woods system, Germany in the EMS) was generally unwilling to allow its money stock to increase and its interest rate to decline

29. Symmetric and asymmetric systems compared • Advantages of the asymmetric system • Discipline on the peripheral country • Disadvantages of the asymmetric system • The business cycles in the peripheral country are likely to be made more intense by the pro-cyclical movements of the money stock of the periphery

30. Disadvantage of asymmetric system: recession in periphery Centre country Peripheral Country rA r1 M1B M1A MA MB Money demand in periphery declines; since centre country keeps interest rate fixed, money supply in periphery must decline; monetary policy is pro-cyclical, aggravating the recession; total money stock in system declines

31. A recession in the peripheral country in a symmetric system Peripheral country Centre country rA rB M2B M1B MB M1A M2A MA In this system central banks cooperate; peripheral country reduces its money stock while centre country increases it; total money stock in system is unchanged

32. Conclusion • Incomplete monetary unions often lack credibility and are often hit by a speculative crisis • Increasing capital mobility increases the fragility of fixed exchange rate regimes • This has put many countries in the uncomfortable dilemma that they have to choose between either more exchange rate flexibility or a monetary union • Fixing exchange rates in Europe can only work as a transitory device towards full monetary union