Lecture 11

1. Lecture 11 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

2. Monetary Policy Instruments • Required Reserves • Permanent Standing Facilities • Open Market Operations

3. Required Reserves • Reserve deposits of banks held at the NCBs. • An increase in the required reserve ratio amounts to contractionary policy since it reduces excess reserves and lending. • A decrease in the required reserve ratio amounts to expansionary policy. • Earn interest at a rate equal to the repo rate • In 2004, the legal required reserve ratio in the EU was between 1.5 and 2.5 percent of the bank’s liabilities. • Rarely used for short-term policy purposes.

4. Permanent Standing Facilities • Similar to the U.S. Fed’s “Discount Window”. • The ECB provides overnight emergency loans to banks short of liquidity. • Some of the loans are made in the form of overnight repurchase agreements, • Others are based on a collateral agreement wherein the borrower provides government securities to the NCB as collateral. • The interest rates on these loans is higher than other ECB rates.

5. Permanent Standing Facilities (2) • Banks with excess overnight liquidity may deposit this at their NCBs. • This is the ECB’s short-term standing deposit facility. • Such deposits receive interest based on the marginal deposit rate, the lowest of ECB rates. • The spread between the deposit rate and borrowing rate form the bounds for overnight market interest rates. • The Governing Council has the authority to change the operating terms of the facility or discontinue it if necessary.

6. Open Market Operations (OMOs) • These are the most important and most often used monetary policy tools available to the ECB. • They are used to manage liquidity and interest rates on a day-to-day basis. • There are four distinct categories regarding the “aim, regularity, and procedures” of open market operations. These are: • Main refinancing operations • Longer-term refinancing operations • Fine-tuning operations • Structural operations

7. OMOs: Main Refinancing Operations • To cover short-run liquidity needs, banks may borrow from their NCB. • The NCBs make the loans by buying high-grade bonds from the borrowing institutions which they hold as collateral. The borrowing institution promise to repurchase the same bonds in two weeks when their loans are repaid. • The Governing Council sets the interest rate on the loans. • Commercial banks offer bids to supply liquidity, which result in reverse repos. • This process provides an important monetary tool, and the largest volume of refinancing to the Euro Area.

8. OMOs: Longer-Term Refinancing Operations • Implemented through regular refinancing held once a month. • These loans have a maturity of 3 months. • Those seeking the loans submit bids, and the loans are awarded competitively. • These are a relatively small part of the ECB’s refinancing volume, and are not used to provide policy signals to the marketplace. • Thus the ECBs are not setting the rate, but rather simply responding to bids.

9. OMOs: Fine-tuning Operations • These are used to smooth out fluctuations of interest rates that may result from unexpected volatility in the market. • These are usually conducted through: • Outright transactions • Foreign exchange swaps • Collection of fixed-term deposits

10. OMOs: Structural Operations • These are OMOs resulting from a need of the Eurosystem to restructure its financial position in relation to the Euro Area financial sector. • The NCBs issue debt certificates, altering the composition of the balance sheet of both the Eurosystem and the financial institutions.

11. Experience with the Euro:Nominal US Exchange Rate • The euro was adopted on January 1, 1999. • The Euro Area countries have agreed to let their currency float against all currencies that had joined the flexible exchange rate regime that followed Bretton Woods. • The euro was introduced at $1.168 relative to the US dollar, which was the US dollar-European Currency Unit (ECU) official exchange rate on the last day of 1998. • That is, the euro replaced the ECU on a one-to-one basis. • The first recorded trading transaction of the euro took place in Australia on January 4, 1999 at $1.175. • In Europe, the euro began trading at a rate of $1.1855.

12. Experience with the Euro:Nominal US Exchange Rate (2) • Almost immediately the euro started depreciating against the US dollar. • This trend continued until the end of 2000. • From mid 2000 to mid 2002, the euro was stable against the dollar, bouncing around the $0.90 level. • In mid 2002 the euro began to appreciate against the dollar. • This concerned European businesses, the EU Council and the ECB because it implied that European exports were becoming more expensive to Americans. • This could slow the sales of exports and damage their still-fragile economic expansions. • The euro reached a high of $1.3633 on Dec. 28, 2004.

13. Dollar-Euro Nominal Exchange Rate

14. Experience with the Euro:Other Nominal Exchange Rates • The first 5 years experience of the exchange rates of the Japanese yen, UK pound sterling, Swiss franc, Canadian dollar, South Korean won, and Chinese yuan were similar to that of the US dollar. • The first 5 were market driven, floating exchange rates, influenced periodically by government interventions. • The Chinese renminbi is pegged to the U.S. dollar at 8.27 yuan to the dollar.

15. Experience with the Euro:Other Nominal Exchange Rates (2) • The Australian dollar (“the aussie”) is a “commodity exchange rate”, driven by movements in the prices of some commodities that they heavily export. • The Swedish krona/euro exchange rate has been stable because Sweden was considering joining the EMU and was been preparing to adopt the euro. • As a result Sweden was obligated to maintain a stable currency versus the euro prior to joining the EMU.

16. Experience with the Euro:Other Nominal Exchange Rates (3)

17. Experience with the Euro:Other Nominal Exchange Rates (4)

18. Nominal vs. Real Exchange Rates • The nominal exchange rate is the rate that is quoted by banks and in the newspapers. • It is the exact number of foreign currency units that can be exchanged for one unit of the domestic currency. • E.g., how many yen can a dollar buy today? • The nominal exchange rate does not tell us explicitly the amount of goods and services that a domestic currency unit (one dollar) would buy in the foreign country. • To determine this, we need to incorporate information about relative prices in the two countries as well. • The nominal exchange rate is also bilateral, meaning it only relates the currencies of two countries.

19. Nominal vs. Real Exchange Rates (2) • Real exchange rates reflect the buying power of the domestic currency unit in terms of the goods and services of the other country. • Real exchange rates are still bilateral, but incorporate price index information. • Which price index? Depending on whether your interest was travel or importing, you might use the a price index reflecting the prices that the average consumer in the country faces, or you might use the average price of the country’s exports.

20. An “Average” Nominal Exchange Rate • Nominal Trade-Weighted Exchange Rate or Nominal Effective Exchange Rate (NEER). (“Trade-weighted dollar”) • This is NOT a bilateral exchange rate. • This is a weighted average of ALL the bilateral exchange rates of the country’s trading partners, weighted according to the volume of trade (trade share) with each country. • In our case, this answers the question “how is the dollar doing overall, against all other currencies?” • Because this is not relative to any single currency, it cannot be constructed as a typical exchange rate. It is constructed like a price index, with a base year set at 100, and other time periods given in relative terms.

21. Nominal Effective Exchange Rate

22. Nominal Effective Exchange Rate (2)

23. An “Average” Real Exchange Rate • This is the Real Trade-Weighted Exchange Rate or Real Effective Exchange Rate (REER). • These incorporate price indexes for the countries involved, and are constructed as indexes with a base year at 100. • A decline in the REER implies that a country’s exports are cheaper to foreigners, which should improve the country’s trade balance.

24. Real Effective Exchange Rate

25. Real Effective Exchange Rate (2)

26. Why an EU Constitution? • It has outgrown its informal rules. • Began in 1951 as a six-nation economic alliance. • By 1995 it had 15 countries and rivaling the U.S. in economic power. • Now it is a confederation of 25 countries, with more to come. • Many decisions still require unanimous agreement of the members. • It was hoped that a constitution would streamline the voting process and create more of a federal structure like the U.S.

27. Definition and objectives of the EU • A Union of peoples and States • The underlying values of the EU • Multiple objectives • Relations between the EU and the Member States based on the principle of loyal cooperation • A Union with legal personality • Exercising competences: the Community model

28. Legal Personality EU OBJECTIVES EU VALUES • Respect for human dignity • Liberty • Democracy • Rule of law • Respect for human rights and for minorities • Pluralism, tolerance, justice • Solidarity, non-discrimination • Equality between women and men • Internal objectives of the Union • External objectives of the Union

29. Multiple Objectives Promotion of peace, the EU’s values and the well being of its peoples • The internal objectives of the Union • The external objectives of the Union

30. Internal Objectives Sustainable development based on balanced economic growth and price stability

31. Internal Objectives (2) A highly competitive social market economy aiming at full employment and social progress PROMOTE JUSTICE AND SOCIAL PROTECTION EQUALITYMEN / WOMEN COMBAT SOCIALEXCLUSION ECONOMIC, SOCIAL AND TERRITORIAL COHESION SOLIDARITYBETWEEN GENERATIONS SOLIDARITY BETWEENSTATES PROTECTIONOF THE RIGHTS OF THE CHILD

32. Internal Objectives (3) Environment and scientific progress Promotion of scientific and technical progress High level of protection and improved quality of the environment

33. Internal Objectives (4) Diversity Respect for the EU’s rich cultural and linguistic diversity Safeguarding and enhancing Europe’s cultural heritage

34. External Objectives The external objectives of the Union Upholding and promoting the EU’s values and interests

35. External Objectives (2) Sustainable development of the earth Security Respect for the principles of the UN Charter Peace Respect for international law Solidarity Protection of the rights of the child Mutual respect between peoples Free and fair trade Eradication of poverty Protection of human rights

36. Fundamental Freedoms THE 4 FREEDOMS OF THE UNION NON-DISCRIMINATION • FREE MOVEMENT OF PERSONS • NON-DISCRIMINATION • ON GROUNDS OF • NATIONALITY • FREE MOVEMENT OF GOODS • FREE MOVEMENT OF SERVICES • FREE MOVEMENT OF CAPITAL

37. Fundamental Freedoms (2) Relations between the Union and the Member States based on the principle of loyal cooperation and on equality of Member States before the Constitution

38. Fundamental Freedoms (3) EUROPEAN UNION PRIMACY OF EUROPEANUNION LAW RESPECT OF NATIONAL IDENTITIES PRINCIPLE OF LOYAL COOPERATION MEMBER STATES

39. Legal Personality The EU can: lRepresent Europe, conclude treaties l Take legal action, belong to international organisations CONSTITUTIONAL TREATY European Union LEGAL PERSONALITY TAKING THE PLACE OF EXISTING LEGAL PERSONALITIES The various Treaties currently governing Europe can be merged into a constitutional Treaty

40. Citizenship National citizenship Union citizenship lRight to move and reside freely within the territory of the Member States lRight to vote and to stand in European Parliament elections and in local elections lRight to enjoy, in the territory of a third country where the citizen’s Member State is not represented, protection from any Member State’s diplomatic and consular authorities lRight to petition the EP, to apply to the Union Ombudsman l Right to write to the institutions and advisory bodies of the Union in any of the EU’s languages

41. Exclusive Domain of the Union • Customs union • Competition rules necessary for the functioning of the internal market • Monetary policy, for the Member States whose currency is the euro • Conservation of marine biological resources under the common fisheries policy • Common commercial policy • Conclusion of an international agreement when : • - its conclusion is provided for in a legislative act of the Union • - It is necessary to enable the Union to exercise its internal competence • - Insofar as its conclusion may affect common rules or alter their scope

42. Shared Domain • Internal market • Social policy, for aspects defined in Part III • Economic, social and territorial cohesion • Agriculture and fisheries, excluding the conservation of marine biological resources • Environment • Consumer protection • Transport, Trans-European networks, Energy • Area of freedom, security and justice • Common safety concerns in public health matters, for aspects defined in Part III • Research, technological development and space • Development cooperation and humanitarian aid

43. Complicated? • The US Constitution is 7 articles and 27 amendments. • The proposed European constitution contains 448 articles, covering more than 300 pages. • It is filled with exceptions to preserve the rights of specific nations to opt out of certain regulations. • It was written by bureaucrats over many years, with the idea of pleasing everyone 100%. • It was voted down by the French, and the British are avoiding voting on it for now.

44. What’s the French Problem? • Voters may have just wanted to express to President Jacques Chirac their displeasure with their high unemployment rates and poor economy. • Some voters may be expressing a form of French nationalism: • They are afraid that the “French economic way of life” is being pushed aside by foreign interests. • The French have preferred short workweeks, long vacations, and emphasized quality of non-economic life over income growth. • They have a lot of socialistic tendencies, high levels of transfers, rigid labor markets dominated by strong centralized unions, etc. • Has the economic integration ignored differences in objectives among members?

45. What about the Dutch? • Like the French, the Dutch are concerned about preserving their way of life. • The Dutch have a freewheeling, libertarian culture. They have legal euthanasia, prostitution, and marijuana bars. • Like the French, they may fear that the admission of a large Muslim nation like Turkey will fuel the growth of Islamic fundamentalism among their large Muslim minority. • Neither the French nor the Dutch want to destroy the EU, they just don’t want to make it stronger.