Theorie und Politik der Europäischen Integration

1. Theorie und Politik der Europäischen Integration Theory and Politics of Eropean Integration Lecture 6 Open EconomiesMacroeconomics MonetaryHistoryof Europe Choice of Exchange Rate Systems Prof. Dr. Herbert Brücker

2. Last Lecture Theory and Politics of European Integration A Monetary History of Europe • 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

3. Last Lecture Theory and Politics of European Integration A Monetary History of Europe • 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

4. This lecture: Monetary Integration (I/II) Theory and Politics of European Integration A Monetary History of Europe • 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

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

6. An Introduction to Open Economy Macroeconomics:Three basic principles Theory and Politics of European Integration A Monetary History of Europe • 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

7. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe short-term AS long-term AS inflationrate AD AD AD: Whydownwardsloping? Inflation erodespurchasing power ofmoneyanddiscouragesconsumptionandinvestment C B A output gap 0 The AS-AD model output gap (Actual – Trend GDP)

8. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe short-term AS long-term AS Inflationrate 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 0 The AS-AD model output gap (Actual – Trend GDP)

9. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe short-term AS long-term AS Inflationrate 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 0 The AS-AD model output gap (Actual – Trend GDP)

10. Long term neutrality implication: PPP Theory and Politics of European Integration A Monetary History of Europe • 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

11. Short term non-neutrality of money Theory and Politics of European Integration A Monetary History of Europe • 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

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

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

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

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

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

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

18. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe interest rate LM LM‘ B Foreignlevel 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)

19. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe interest rate LM LM‘ B Foreignlevel 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)

20. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe interest rate LM LM‘ B Foreignlevel 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)

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

22. Exchange rate regimes and policy effectiveness Theory and Politics of European Integration A Monetary History of Europe

23. When does the regime matter? Theory and Politics of European Integration A Monetary History of Europe • 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

24. A Monetary History of Europe 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.

25. Metallic Money Theory and Politics of European Integration A Monetary History of Europe • 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

26. Metallic Money: Some Details Theory and Politics of European Integration A Monetary History of Europe • 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

27. Gold standard: The Global Monetary Union Theory and Politics of European Integration A Monetary History of Europe • 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

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

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

30. Neutrality of money and current account equilibrium Theory and Politics of European Integration A Monetary History of Europe price level A current account deficit E 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

31. Neutrality of money and current account equilibrium Theory and Politics of European Integration A Monetary History of Europe price level A current account deficit E 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

32. Balance of payment equilibrium Theory and Politics of European Integration A Monetary History of Europe BoP E 0 M0 gold money M A inflow of money outflow of money

33. Balance of payment equilibrium Theory and Politics of European Integration A Monetary History of Europe • 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 0 M0 gold money M A inflow of money outflow of money

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

35. Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe 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

36. Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe 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

37. Financial account equilibrium Theory and Politics of European Integration A Monetary History of Europe interest rate A E financial account surplus i* financial account deficit • Relation betweenfinancial and currentaccount: • Capital inflowrequireshighinterest rate and increasesprices • Both capital and currentaccountdeteriorate • Trade route isslower, but bothwork in same direction • In the long-term, capital flowsequaliseinterest rates, currentaccountadjusts, suchthat the currentaccount, capital balance and BoPis in equilibrium. M0 M gold money

38. Monetary equilibrium under gold standard Theory and Politics of European Integration A Monetary History of Europe • 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.

39. Monetary equilibrium under gold standard Theory and Politics of European Integration A Monetary History of Europe • 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)

40. Rules of the game and problems Theory and Politics of European Integration A Monetary History of Europe • 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

41. Similarities to the EMU Theory and Politics of European Integration A Monetary History of Europe • 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

42. The interwar period: the worst of all worlds Theory and Politics of European Integration A Monetary History of Europe • 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

43. The interwar period: three case studies Theory and Politics of European Integration A Monetary History of Europe • ·The British case: return to gold standard pre-war parity andrefusal 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.

44. Lessons so far Theory and Politics of European Integration A Monetary History of Europe • ·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

45. European post-war arrangements Theory and Politics of European Integration A Monetary History of Europe • ·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

46. European postwar arrangements (cont.) Theory and Politics of European Integration A Monetary History of Europe • ·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

47. The EMS: Super Snake Theory and Politics of European Integration A Monetary History of Europe • ·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

48. From EMS to EMU (EURO) Theory and Politics of European Integration A Monetary History of Europe • ·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

49. Lessons from history Theory and Politics of European Integration A Monetary History of Europe

50. The choice of an exchange rate regime Theory and Politics of European Integration A Monetary History of Europe • 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