© Vera E. Troeger
EC 134: Topics in Applied Economics (1a)
Week 7: Monetary Policy in Open Economies: Currency
Unions and Fear of Floating
1.
2.
3.
4.
5.
6.
7.
8.
9.
Exchange Rates
Determinants of Exchange-Rates
Exchange-Rate Systems
Exchange-Rate Regimes
Pros and Cons of Fixed Exchange-Rates
Mundell-Fleming theorem: The ‘Unholy Trinity’
Optimal Currency Areas
“Fear of Floating”
External Effects of Currency Unions
© Vera E. Troeger
Exchange Rates
The Dollar/Euro Exchange Rate
The Yen/Dollar Echange Rate
What is an exchange-rate?
An exchange rate is the rate at which one currency can be exchanged for another. In
other words, it is the value of another country's currency compared to that of your own
(and vice versa).
What drives exchange-rates?
© Vera E. Troeger
…in the short run?
we don’t know or:
alternatively
sentiments
rumors
expectations about the expectations of other investors
events (shocks)
… in the long run?
the relative ratio of productivity growth and inflation
expectations about productivity and inflation
 policies
© Vera E. Troeger
The Politics of Investor Confidence
a depreciation of the domestic currency is caused by
reduction in interest rate (c.p.)
decline in economic growth (c.p.)
increase in inflation (c.p.)
decline in productivity growth (c.p.)
high wage increases (c.p.)
electoral success of left-wing party ? (c.p.)
increase in government debt (c.p.)
increase in government spending? (c.p.)
country-specific demand shocks (c.p.)
else?
© Vera E. Troeger
Exchange-Rate Systems
Bretton Woods:
Gold-Dollar Standard
all countries pegged their currency to the dollar
the value of the Dollar was expressed in gold
US promised to exchange Dollars in gold
all countries but the USA had to defend the parities
problems: misalignment of exchange-rate, the Dollar
© Vera E. Troeger
since 1973
anything goes (most important currencies float to each other)
problems: (surprisingly) high volatility
© Vera E. Troeger
Exchange-Rate Regimes
Flexible Exchange-Rate
the market decides on the relative value of the currency
Managed Float
in principle the currency floats, but the government may under certain circumstance
intervene
Fixed Exchange Rate
Fixed to Key Currency (Dollar, Euro, Yen?)
Fixed to Currency Basked
the government(s) has/have the obligation to intervene
important: parities, bandwidths
© Vera E. Troeger
Currency Board
Value of Issued Money held in Reserves
Dollarization
Introduction of Dollar/ Euro/ Franc/ Pound as SOLE Means of Payments
Currency Union
Introduction of Common Currency (and common monetary policy)
© Vera E. Troeger
Why do some countries peg their currency, and other float?
Advantages of stable exchange-rates:
stable expectations
no need to insure against exchange-rate risks
(futures, hedges,…)
 low transactions costs to trade
 more trade (Andrew Rose)
 higher economic growth (?)
Disadvantages of fixed exchange-rates
risk of severe misalignment
speculative attacks on exchange-rate peg
reduction in monetary policy autonomy
© Vera E. Troeger
Paul Krugman on the Global System of Flexible ExchangeRates
(http://www.econlib.org/library/Enc/ExchangeRates.html)
Exchange rates between currencies have been highly unstable since the collapse of the Bretton Woods system of fixed exchange rates, which
lasted from 1946 to 1973. Under the Bretton Woods system, exchange rates (e.g., the number of dollars it takes to buy a British pound or
German mark) were fixed at levels determined by governments. Under the "floating" exchange rates we have had since 1973, exchange
rates are determined by people buying and selling currencies in the foreign-exchange markets. The instability of floating rates has surprised
and disappointed many economists and businessmen, who had not expected them to create so much uncertainty. The history of the pound
sterling/U.S. dollar rate is instructive. From 1949 to 1966, that rate did not change at all. In 1967 the devaluation of the pound by 14
percent was regarded as a major economic policy decision. Since the end of fixed rates in 1973 and 1991, however, the pound, on average,
either appreciated or depreciated by 14 percent every two years.
The instability of exchange rates in the seventies and eighties would not have surprised the founders of the Bretton Woods system, who had
a deep distrust of financial markets. The previous experience with floating exchange rates (in the twenties) had been marked by massive
instability. In an influential study of that experience, published in 1942, Norwegian economist Ragnar Nurkse argued that currency markets
were subject to "destabilizing speculation," which created pointless and economically damaging fluctuations.
During the fifties and sixties, however, as stresses built on the system of fixed exchange rates, both economists and policymakers began to
see exchange rate flexibility in a more favorable light. In a seminal paper in 1953, Milton Friedman argued that the fear of floating exchange
rates was unwarranted. Unstable exchange rates in the twenties, he maintained, were caused by unstable policies, not by destabilizing
speculation. Friedman went on to argue that profit-maximizing speculators would always tend to stabilize, not destabilize, the exchange rate.
By the late sixties Friedman's view had become widely accepted within the economics profession and among many businessmen and
bankers. Therefore, concern over the instability of floating exchange rates was replaced by an appreciation of the greater flexibility that
floating rates would give to macroeconomic policy. The main advantage was that nations could pursue independent monetary policies and
adjust easily to eliminate payments imbalances and offset changes in their international competitiveness. This change in attitude helped to
prepare the way for the abandonment of fixed rates in 1973.
© Vera E. Troeger
The instability of rates since 1973 has thus been a severe disappointment. Some of the changes in exchange rates can be attributed to
differences in national inflation rates. But yearly changes in exchange rates have been much larger than can be explained by differences in
inflation rates or in other variables such as different growth rates in various countries' money supplies.
Why are exchange rates so unstable? Economists have suggested two explanations. One, originally expressed in a celebrated 1976 paper by
MIT economist Rudiger Dornbusch, is that even without destabilizing speculation, exchange rates will be highly variable because of a
phenomenon that Dornbusch labeled "over-shooting." Suppose that the United States increases its money supply. In the long run this must
cause the value of the dollar to be lower; in the short run it will lead to a lower interest rate on dollar-denominated securities. But as
Dornbusch pointed out, if the interest rate on dollar-denominated bonds falls below that on other assets, investors will be unwilling to hold
them unless they expect the dollar to rise against other currencies in the future. How can the prospect of a long-run lower dollar and the
need to offer investors a rising dollar be reconciled? The answer, Dornbusch asserted, is that the dollar must fall below its long-run value in
the short run, so that it has room to rise. That is, if the U.S. money supply rises by 10 percent, which will eventually mean a 10 percent
weaker dollar, the immediate impact will be a dollar depreciation of more than 10 percent—say 20 or 25 percent—"overshooting" the longrun value. The overshooting hypothesis helps explain why exchange rates are so much more unstable than inflation rates or money supplies.
In spite of the intellectual appeal of the overshooting hypothesis, many economists have returned to the idea that destabilizing speculation is
the principal cause of exchange rate instability. If those who buy and sell foreign exchange are rational, then forward exchange rates—rates
today for sale of dollars some months hence—should be the best predictors of future exchange rates. But a key study by the University of
Chicago's Lars Hansen and Northwestern University's Robert Hodrick in 1980 found that forward exchange rates actually have no useful
predictive power. Since that study many other researchers have reached the same conclusion.
At the same time, particular exchange rate fluctuations have seemed to depart clearly from any reasonable valuation. The run-up of the
dollar in late 1984, for example, brought it to a level that priced U.S. industry out of many markets. The trade deficits that would have
resulted could not have been sustained indefinitely, implying that the dollar would have to decline over time. Yet investors, by being willing
to hold dollar-denominated bonds with only small interest premiums, were implicitly forecasting that the dollar would decline only slowly.
Stephen Marris and I both pointed out that if the dollar were to decline as slowly as the market appeared to believe, growing U.S. interest
payments to foreigners would outpace any decline in the trade deficit, implying an explosive and hence impossible growth in foreign debt. It
was therefore apparent that the market was overvaluing the dollar. Overall, there is no evidence supporting Friedman's assumption that
speculators would act in a rational, stabilizing fashion. And in several episodes Nurkse's fears of destabilizing speculation seem to ring true.
© Vera E. Troeger
What are the effects of exchange rate instability? The effects on both the prices and volumes of goods and services in world trade have been
surprisingly small. During the eighties real West German wages went from 20 percent above the U.S. level to 25 percent below, then back to
30 percent above. One might have expected this to lead to huge swings in prices and in market shares. Yet the effects, while there, were
fairly mild. In particular, many firms seem to have followed a strategy of "pricing to market" (i.e., keeping the prices of their exports stable
in terms of the importing country's currency). Significant examples are the prices of imported automobiles in the United States, which
neither fell much when the dollar was rising nor rose much when it began falling. Statistical studies, notably by Wharton economist Richard
Marston, have documented the importance of pricing to market, especially among Japanese firms.
The policy implications of unstable exchange rates remain a subject of great dispute. Refreshingly, this is not the usual debate between
laissez-faire economists who trust markets and distrust governments, and interventionist economists with the opposite instincts. Instead,
both camps are divided, and advocates of both fixed and floating rates find themselves with unaccustomed allies. Laissez-faire economists
are divided between those who, like Milton Friedman, want stable monetary growth and therefore want to leave the exchange rate alone,
and those who, like Columbia University's Robert Mundell, want the discipline of fixed exchange rates and even a return to the gold
standard. Interventionists are divided between those who, like Yale's James Tobin, regard exchange rate instability as a price worth paying
for the freedom to pursue an activist monetary policy, and those who, like John Williamson of the Institute for International Economics,
distrust financial markets too much to trust them with determining the exchange rate.
In general, sentiment among both economists and policymakers has drifted away from belief in freely floating rates. On the one hand, exchange
rates among the major currencies have been more erratic than anyone expected. On the other hand, the European Monetary System, an experiment
in quasi-fixed rates, has proved surprisingly durable. Taking the long view, however, attitudes about exchange rate instability have repeatedly
shifted, proving ultimately as poorly grounded in fundamentals as the rates themselves.
© Vera E. Troeger
The Open Economy Trilemma: Mundell-Fleming Theorem
How are fixed exchange rates and monetary policy related?
Mundell-Fleming theorem (unholy trinity):
Government can only reach two of the following three policy goals simultaneously:
 stable exchange rates
 absence of capital controls
 monetary policy autonomy
With unarguably high capital mobility governments face the dilemmatic choice between
monetary policy flexibility and stable exchange rates.
The Mundell-Fleming theorem dominates current research in Comparative Political
Economy, and…
© Vera E. Troeger
… the ideology of the IMF
“So what did our experience in the 1990s teach us about delivering growth and
prosperity? Several important lessons stand out. First and foremost is the crucial
importance of a flexible exchange rate regime. Fixed exchange rate regimes pose
significant challenges because they mean fiscal and monetary policies must always be
consistent with the exchange rate regime and subordinated to it. The countries affected
by capital account crises were all hampered in their initial response to trouble by fixed or
heavily managed exchange rate regimes.”
Anne O. Krueger, First Deputy Managing Director of the IMF, May 2006
“While most of us, faced with an unconstrained choice, would opt for arrangements
that promise greater exchange rate stability, I think we must also recognize that the
global environment is even less hospitable to such a system today than it was 25 years
ago. Realistically, there is no alternative to floating exchange rates […]”
Horst Köhler, Managing Director of the IMF, January 2001
© Vera E. Troeger
Currency Unions
Benefits of intensified trade and loss of monetary independence
On the one hand, members of currency unions benefit since a joint currency decreases
trading costs induced by exchange rate risks and hence generates efficiency gains.
On the other hand, governments of member states have to surrender monetary policy
autonomy to the union’s central bank and can no longer tailor their policy to country
specific exogenous shocks
Price and monetary stability
Credibility beyond fixed exchange-rate system
One currency decreases transaction costs for trade
Else?
Alesina/ Barro 2002
© Vera E. Troeger
Optimal Currency Areas
One currency?
No exchange rate risks
Simultaneity of Economic Business Cycles?
Trade
Co-movements of output and prices
Impact of CU on trade and co-movements
Does market integration decrease the optimal number of currencies?
© Vera E. Troeger
EXAMPLE: GREXIT
The Euro-crisis, Eurozone and Grexit (Iversen/Soskice)
Institutionally speaking, the Eurozone is not an optimal currency area:
▪ the main problem is a deep structural-institutional imbalance in the Eurozone
▪ Eurozone institutions were built around a northern European (NE) model of
capitalism, which is not compatible with southern European (SE) institutions.
 KNOWN AT THE BIRTH OF EMU
▪ Reforms are blocked by insiders in the South.
▪ Major debt restructuring is blocked by voters in the North (esp. Germany)
▪ Yet Grexit (and a wider breakup) is too costly for all.
This creates a “curse” of a large bargaining space, resulting in a protracted war of attrition
(and continued austerity).
© Vera E. Troeger
NE export model of capitalism
▪ Export-sector led growth based on coordinated wage bargaining, a strong nonaccommodating CB, and effective training institutions
▪ Wage restraint is reinforced by inter-sectoral compression
▪ Net result: high competitiveness and demand for skilled workers. Demand is
accommodated through effective training systems, e.g. Germany
▪ Institutional equilibrium is under-written by a political compromise between export
employers, skilled unions, and at least a portion of the low-skilled (who benefit from
training)
▪ Empirical correlates: high competitiveness and high domestic price levels
© Vera E. Troeger
SE dualism “model”
▪ Division between a formal sector with strong but uncoordinated unions, high
protection and wages; and a large informal sector with weak unions, and low
protection and wages
▪ Macroeconomic policies were (before the Euro) mildly inflationary and linked to
occasional devaluations (plus capital controls)
▪ Inter-sectoral inequality is high and demand for skilled labor low, with
underdeveloped training systems
▪ Institutions are under-written by an insider political coalition that largely excludes
workers in the informal sector, as well as export interests.
▪ Empirical correlates: Low competitiveness and low domestic price levels
© Vera E. Troeger
Two clusters of euro-zone countries
© Vera E. Troeger
Effect of common currency
▪ NE: Large gain (growth) from fixed exchange rates and real depreciation of exports
to SE. New investment opportunities in SE as devaluation risk disappears (at least in
short term).
▪ SE: Short- and medium-term gain as capital flowed in from the surplus countries. But
eventually massive loss from real appreciation and steeply rising debt costs b/c of
the risk of depreciation (euro exit). No off-setting effects of the ECB.
© Vera E. Troeger
Trade divergence
© Vera E. Troeger
The southern European risk premium on long term interest rates from the
Maastricht Treaty to 2011
© Vera E. Troeger
The trade deficit and long term interest rates in 2011
© Vera E. Troeger
Solutions?
▪ (1) Breakup of the euro: long-term viability, but huge short- and medium-term costs
because of uncertainty, capital flight, etc. Costs so high that a bargain to avoid
GREXIT (and keep SE as a whole) always seems feasible
▪ (2) Institutional reform in SE: flexibilize labor markets and break down insider
protections  better downward adjustment of wages and more balanced trade. But
again huge short-term costs that are blocked by insiders as long as (1) is ruled out.
▪ (3) Large transfer from north to south (deep debt restructuring) – a “Marshall plan” for
SE. SE would recover and buy NE exports again. Sustainable at least in the medium
run, but blocked by German voters as long as (1) is ruled out.
▪ (4) Japanese-style austerity. (Or very gradual recovery as US and China markets
pick up).
© Vera E. Troeger
The curse of a large bargaining space: War of attrition
© Vera E. Troeger
Long run: Optimistic scenario
© Vera E. Troeger
Long run: Pessimistic scenario
▪ Continued austerity unacceptable to France and Italy  Germany given an
ultimatum: Either total break-up or acceptance of much more accommodating
policies: Governments allowed raising their deficits and ECB engaging in large-scale
quantitative easing.
▪ Already: France blowing through the deficit ceiling – inaugural visit of Manuel Valls in
Germany
▪ Problem: If this really happens North (Germany) is likely to prefer a break-up
Thoughts? Predictions?
© Vera E. Troeger
Fear of Floating
No small country enjoys monetary flexibility and all governments must maintain a tight
connection to the interest rate of the relevant base economy. (Calvo/ Reinhart)
Countries with flexible exchange-rates do often not enjoy full monetary policy autonomy
but rather take into account the exchange-rate effects when making monetary policy
choices. Accordingly, most governments are forced to bring their own monetary policy in
line with the relevant base country.
Exchange-rate pass-trough
© Vera E. Troeger
The UK outside the EMU
Insider vs. Outsider Perspective
Benefits and Costs of Currency Unions
Stable currency and monetary policy (trade, investment and borrowing) vs. Monetary
Policy Autonomy esp. during economic crises
Necessary condition for CU: similar economic and labor market institutions and economic
business cycles
© Vera E. Troeger
UK: £ and flexibility
© Vera E. Troeger
Bank Cross-Border Position: Assets in bn $
Currency Denomination of BIS reporting Bank’s Cross Border Positions (Assets),
1977-2004 (BIS 2004)
7000
6000
5000
4000
3000
Dollar
Euro
2000
Yen
1000
0
Q3 1982
Q3 1987
Q3 1992
Year
Q3 1997
Q3 2002
© Vera E. Troeger
© Vera E. Troeger
0.8
0.8
0.6
0.6
effect of US interest rate
effect of Ger/ EMU interest rate
Findings: The Impact of the EMU and US MP on Non-EURO EU Countries
0.4
0.2
0.4
0.2
0.0
0.0
-0.2
-0.2
1988
1992
1996
2000
2004
year
figure 1a: the impact of EMU interest rate on
non-EURO EU countries' interest rate
1988
1992
1996
2000
2004
year
figure 1b: the impact of US interest rate on
non-EURO EU countries' interest rate
© Vera E. Troeger
Dependent variable:
changes of real interest
rates
Mean Equation:
Intercept
Level of Real Interest Rate
Δ Real Interest Rate
80-90
Δ Real Interest Rate
Ger/Euro, 90-94
Δ Real Interest Rate
zone, 94-99
Δ Real Interest Rate
zone, 99-02
Δ Real Interest Rate
zone, 02-05
Δ Real Interest Rate
80-90
Δ Real Interest Rate
90-94
Δ Real Interest Rate
94-99
Δ Real Interest Rate
99-02
Δ Real Interest Rate
02-05
Domestic Growth
Ger,
EuroEuroEuroUSA,
USA,
USA,
USA,
USA,
Growth
Germany/Eurozone
Growth USA
Domestic Unemployment
FE
Model 4: EU,
trade
weighted
(UK, DNK,
SWE)
Model 5:
EFTA, trade
weighted
(NOR, SWI)
Model 6:
NonEuropean,
trade
weighted
(AUS, NZ)
Model 7:
CAN
trade
weighted
-0.085
(0.066)
0.037***
(0.012)
0.066
(0.114)
0.032
(0.079)
0.244***
(0.092)
0.324***
(0.102)
0.601***
(0.101)
-0.067
(0.044)
0.137***
(0.055)
0.066
(0.049)
0.025
(0.021)
0.008
(0.020)
-0.296**
(0.123)
0.087***
(0.020)
0.278***
(0.085)
0.044
(0.058)
0.026
(0.108)
0.390**
(0.200)
0.361**
(0.185)
0.033
(0.032)
0.201***
(0.039)
0.174***
(0.061)
0.043*
(0.027)
0.112***
(0.031)
-0.120
(0.291)
0.035
(0.037)
-0.477
(0.385)
-0.260
(0.195)
0.113
(0.173)
0.113***
(0.029)
0.033
(0.056)
0.029
(0.050)
0.367*
(0.197)
0.241**
(0.124)
0.069
(0.237)
0.207
(0.165)
-0.023
(0.193)
0.037**
(0.016)
-0.069
(0.091)
0.130
(0.203)
0.237
(0.252)
0.007
(0.056)
0.132
(0.123)
0.491***
(0.056)
0.738***
(0.185)
0.624*
(0.376)
0.718***
(0.163)
0.934***
(0.181)
-0.002
(0.008)
-0.003
(0.006)
0.010
(0.007)
0.009
(0.006)
0.019
(0.024)
0.003
(0.008)
-0.011
(0.015)
-0.002
(0.009)
0.029***
(0.010)
-0.003
(0.009)
-0.001
(0.022)
0.032
(0.023)
-0.021**
(0.011)
Yes
-0.012
(0.015)
Yes
-0.033
(0.030)
Yes
-0.028
(0.020)
No
© Vera E. Troeger
More Research:
Monetary Policy Flexibility in Floating Exchange Rate Regimes
Which factors determine the de facto monetary policy autonomy of (small) open
economies with flexible exchange rate systems?
2 Explanations:
Trading relations with key currency areas
Currency denomination of bank cross border assets
© Vera E. Troeger
Trade and Cross-border Banking Assets
De facto monetary policy autonomy is limited by the influence of monetary policy on the
exchange-rate and (thus) on the current account.
This constraint is stricter if
the amount of imports of goods and services from the key currency area is large and
the share of assets denominated in the base currency is large.
© Vera E. Troeger
A Model: open economy
The optimal policy choice depends on a) the degree to which governments maximize
output and consumption by counterbalancing exogenous shocks and b) the exchange
rate effects of domestic monetary policy settings:
Lg   Ct t   t   zb E / I
2
The exchange rate to a key currency depends on a) asset shares denominated in the key
currency and b) the difference between domestic and foreign interest rate policy:
Ab
zb 
A
i  i
t
b
b

b

i

i


z

A
i

i





t 1
t
t 1
b
t
t 
Imported inflation depends on the amount of goods imported from a particular key
currency area
 Ib I  E 
 t  t 1    it  it 1   zb 

Y 
 I
© Vera E. Troeger
Exchange-Rate Effects
A reduction in interest rates in country i leads to a depreciation of i’s currency and thus an
increase in the prices of imported goods, ceteris paribus.
The more the domestic economy imports from the key currency area the higher is the
imported inflation.
The specific (bilateral) exchange-rate effects are largely determined by the decision of
capital owners which currency they choose as ‚safe haven‘ for their assets.
Exchange rate effects enforced by import and asset shares shape the optimal domestic
monetary policy decision of governments
© Vera E. Troeger
Optimal domestic policy for different values of the interest rate in the
base country and import share of the key currency area:
4.0
st rate
3.5
optimal domestic intere
3.0
2.5
2.0
1.5
at
e
tr
es
0.5
te
r
0.4
0.6
e of
0.7
impo
0.8
rts fr
to al
0.9
om b
l imp
1.0
a se
orts
coun
and
dom
try
estic
GDP
in
shar
0.3
se
0.2
ba
1.0
0.0 0.1
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
© Vera E. Troeger
Optimal domestic policy for different values of the interest rate in the
base country and assets denominated in the base currency:
4.0
st rate
3.5
optimal domestic intere
3.0
2.5
2.0
1.5
es
tr
0.5
te
r
0.4
0.6
e of
0.7
asse
0.8
ts de
n
i n ba
omin 0.9 1.0
se cu
ated
rrenc
y
in
0.3
shar
se
0.2
ba
0.0 0.1
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
at
e
1.0
© Vera E. Troeger
Optimal Monetary Policy in an Open Economy
Optimal monetary policy in open economies depends on:
a) the strengths and idiosyncrasy of exogenous shocks,
b) the effect of monetary policy on import prices and inflation,
c) the effect of cross border assets on the exchange-rate to the key
currency.
 Governments have strong incentives to stabilizes the exchange rate to the currency of
their main trading partners.
© Vera E. Troeger
Predictions of the Model
Small countries with floating exchange rate systems enjoy only limited monetary policy
flexibility.
The impact of the monetary policy of a key currency area depends on the relative amount
of imported goods and services from this area.
The effect of the key currency’s monetary policy hinges on the amount of assets
denominated in the key currency.
© Vera E. Troeger
Data
 Monthly interest rates of 38 countries from Europe, North America, Oceania, Asia,
Africa, and Latin America (discount and lending rates):
• 45 % crawling or moving bands (with both appreciation and depreciation
possible)
• 55 % free or managed float
 Time period: 1980 – 2004
 Monthly import shares from EMU and US (IMF direction of trade statistics)
 Currency denomination (EURO or US Dollar) of national banks’ cross border assets
(Bank for International Settlements) – for 20 countries
 Controls: export share, CBI, capital mobility, elections, GDP growth, unemployment
© Vera E. Troeger
Africa
Asia
Egypt
Morocco
South Africa
Hong Kong
Indonesia
Japan
Korea
Malaysia
Philippines
Thailand
Europe
Latin
America
Argentina
Bolivia
Brazil
Chile
Colombia
Mexico
Peru
Uruguay
Venezuela
Oceania
North
America
Canada
Austria
Australia
(Belgium)
New Zealand
Denmark
Finland
France
Greece
Iceland
Ireland
Italy
(Luxembourg)
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
United
Kingdom
Luxembourg and Belgium are not part of the analysis since they follow pegged regimes
throughout the period under observation
© Vera E. Troeger
Region
Europe
Latin America
Asia
Africa
Australia and New Zealand
Canada
Region
Europe
Latin America
Asia
Australia
Canada
Share of cross border
assets
EURO
US$
0.29
0.40
0.07
0.76
0.07
0.54
0.02
0.70
0.02
0.80
Share of Imports of Goods and Services
EMU
US
0.48
0.07
0.17
0.30
0.16
0.10
0.10
0.47
0.34
0.12
0.07
0.65
Before 1999
EURO
0.22
0.05
0.02
0.02
US$
0.44
0.50
0.80
0.83
After 1999
EURO
0.48
0.07
0.11
0.03
0.02
US$
0.29
0.76
0.62
0.53
0.73
.8
.4
.6
US$
.2
Euro
JPY
CHF
GBP
0
% of assets hold in foreign currencies
© Vera E. Troeger
01/80
05/83
09/86
05/93
01/90
Date
09/96
01/00
05/03
© Vera E. Troeger
Econometric Model
real interest rates: governments/monetary authorities are able to control real interest
rates
first differenced data: methodological: unit roots; theoretical: short term adjustments
Garch(1,1) specification: control for time-dependent error variance – increase efficiency
Main IV: changes in EMU/US real interest rates weighted by import/ asset shares
Spatial lags: evenly weighted or weighted with distances/import share: no significant
effect (not reported)
© Vera E. Troeger
DV: monthly change of real
CB interest rate
Intercept
Real CB interest rate (t-1)
Model 1.1
Flex WKS
0.076
(0.119)
-0.044***
(0.004)
Δ real interest rate GER/EMU
0
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2
9
8
© Vera E. Troeger
DV: monthly change of real
CB interest rate
Intercept
Real CB interest rate (t-1)
Model 1.1
Flex WKS
0.076
(0.119)
-0.044***
(0.004)
Δ real interest rate GER/EMU
0
.
(
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Model 1.5
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4
0
.
1
0
7
0
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1
2
0
.
0
1
1
)
)
© Vera E. Troeger
GDP Growth
0.012***
(0.002)
0.007**
(0.003)
0.016
(0.019)
Unemployment
Capital Mobility (CAP)
CAP* Δ real interest rate
G
C
A
P
Δ
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r
e
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(0.003)
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(0.003)
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(0.020)
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(0.003)
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(0.020)
t 1
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.
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e
 
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1
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6
.
2
9
8
© Vera E. Troeger
DV: monthly change of real
CB interest rate
Intercept
Real CB interest rate (t-1)
Model 2.1
Flex WKS
-0.216***
(0.030)
-0.085***
(0.001)
Δ real interest rate GER/EMU
0
.
(
Δ
r
e
a
l
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1
1
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8
Model 2.4
+Democ
0.284***
(0.092)
-0.024***
(0.002)
(
*
2
0
*
0
.
)
(
.
0
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4
5
0
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4
2
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0
6
1
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0
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1
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4
4
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2
0
9
2
4
Model 2.5
- Hyperinfl
0.143
(0.106)
-0.051***
(0.002)
0
4
1
2
4
5
9
0
)
*
8
*
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0
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2
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4
1
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5
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4
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0
.
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3
1
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3
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*
3
)
S
(
L
0
8
Model 2.3
+ Capmob.
0.264***
(0.099)
-0.023***
(0.002)
U
r
e
t
t
M
m
h
a
3
.
(
Δ
2
Model 2.2
Flex WKS
0.813***
(0.057)
-0.096***
(0.001)
0
0
0
0
0
2
.
0
*
3
5
1
.
6
7
*
2
3
0
8
(
*
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7
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2
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5
8
0
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-
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)
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2
5
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4
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3
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1
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3
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2
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(
0
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0
0
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0
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3
3
*
0
7
4
)
4
2
*
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0
1
8
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0
7
5
0
.
0
8
1
0
.
0
1
2
0
.
0
1
0
)
)
© Vera E. Troeger
Results
Governments adjust their interest-rate to the monetary policy in the key currency area
even if they have implemented a flexible exchange-rate system.
De facto monetary policy autonomy is lower if
 countries import more from the key currency area
 capital owners hold their asset in the key currency
Governments in small, open economies face a dilemmatic choice between stabilizing the
exchange rate to this key currency and using monetary policy to stimulate the domestic
economy.
The smaller and more open the economy is, and the more synchronized its business
cycle with that of the key currency area, the more important becomes exchange-rate
stability and the less important monetary policy autonomy.