Chapter 1: The Foreign Exchange Market
1.1 Introduction
Foreign exchange market: market where various national currencies are bought and sold.
Usually when importing goods or services, the buyer has to pay the foreign country in that
foreign country’s currency. The main centre for foreign exchange trading is London.
1.2 Exchange rate definitions
Exchange rate: the price of one currency in terms of another. There are two methods of
expressing it:
1. Domestic currency units per unit of the foreign currency, for example $1.58/£1 (where
the pound sterling is the foreign currency); and
2. Foreign currency units per unit of domestic currency, for example £0.6329/$1.
In this book we solely use the first definition. Using the first expression, a rise in the exchange
rate to $1.80/£1 would mean that more dollars are required to purchase one pound, so that the
pound has appreciated (or the dollar has depreciated). The bid rate is the rate at which a bank
will buy a currency, while the offer rate is the rate at which the bank will sell the currency in
exchange for another currency. The difference is known as the bid-offer spread and represents
the gross profit margin of the bank. Thinly traded currencies tend to have the largest spread,
which usually increases if the risks of trading in a particular currency are perceived as having
risen.
1.3 Characteristics and participants of the foreign exchange market
The foreign exchange market is made up primarily of commercial banks, foreign exchange
brokers and other authorized agents. The US dollar is known as a vehicle currency, because
the currency is widely used to denominate international transactions. It is usually cheaper to
purchase $ with € and then purchase ¥ with $, than to directly purchase ¥ with €. The main
participants in the foreign exchange market are:
1. Retail clients – businesses, international investors, multinational corporations
etc. They do not directly purchase/sell currencies but place orders with the
commercial banks.
2. Commercial banks carry out orders from their retail clients and buy/sell
currencies on their own account (proprietary trading) to change the structure of
their assets and liabilities in different currencies. The banks deal either directly
with other banks or through foreign exchange brokers.
3. Foreign exchange brokers – they collect, buy and sell quotations for most
currencies from many banks, so the most favorable quotation for a bank is
obtained quickly and at very low costs. A brokerage fee needs to be paid.
4. Central banks – intervene frequently to buy and sell their currencies in a bid to
influence the rate at which their currency is traded. Under a fixed exchange rate
system they are obliged to intervene.
1.4 Arbitrage in the foreign exchange market
A consequence of the close communication is that there is almost instantaneous arbitrage
across currencies and financial centers (the exploitation of price differentials for riskless
profits). We assume that transaction costs are negligible and that there is only a single
exchange rate quotation, ignoring the bid-offer spread.
1. Financial center arbitrage – ensures that the dollar-pound exchange rate quoted in
New York will be the same as that quoted in London and other financial centers.
2. Cross currency arbitrage. Suppose that the exchange rates are $1.30/€1 and
$1.58/£1. Currency arbitrage implies that the exchange rate of the euro against the
pound will be €1.2154/£1 (which is 1.58 divided by 1.30).
1.5 The spot and forward exchange rates
Dealing rates for each currency are known as the sport and forward rates. The spot exchange
rate is the quotation between two currencies for immediate delivery - The current exchange
rate of two currencies vis-à-vis each other. The forward exchange rate: it is possible for
economic agents to agree today to exchange currencies at some specified time in the future,
most commonly in one month, three months, six months, nine months and one year.
1.6 Nominal, real and effective exchange rates
We can analyze the implications of exchange rate changes for the economy and the balance of
payments. The nominal exchange rate is the exchange rate that prevails at a given date. The
nominal exchange rate is merely the price of one currency in terms of another with no
reference made to what this means in terms of purchasing power of goods/services. A
depreciation or appreciation of the nominal exchange rate does not necessarily imply that a
country has become more or less competitive on international markets. The real exchange
rate:
The real exchange rate is the nominal exchange rate adjusted for relative prices between the
countries under consideration. Where Sr is the index of the real exchange rate, S is the
nominal exchange rate in index form, P is the index of the domestic price level and P∗ is the
index of the foreign price level. For the first period, the real exchange rate index is set equal
to 100. Intuitively, 120 is an increase and 90 is a decrease (which means an improvement in
competitiveness). The real exchange rate thus monitors changes in a country’s
competitiveness.
Most countries are concerned with what is happening to their exchange rate against a basket
of foreign currencies with which the country trades. The effective exchange rate is a measure
of whether or not the currency is appreciated or depreciated against a weighted basket of
foreign currencies. If the US conducts 30% of its foreign trade with the UK then 0.3 is the
weight attached to the bilateral exchange rate index. While the nominal effective exchange
rate is easy to compile on a daily basis and normally provides a reasonable measure of
changes in a country’s competitive position for periods, it does not take into account the
effect of price movements.
1.7 A simple model of the determination of the spot exchange
The model we will discuss is a model of supply and demand for pounds on the foreign
exchange market. The basic tenet is that the exchange rate (the price) of a currency can be
analyzed like any other price. The demand for pounds in the foreign exchange market is a
derived demand – the pounds are not demanded because they have an intrinsic value in
themselves, but rather because of what they can buy. As the pound appreciates against the
dollar, the exchange rate increases, then the price of the UK export to US importers increases,
which leads to a lower quantity of exports and with it a reduced demand for pounds. In this
model, the demand for pounds depends upon the demand for UK exports, so any factor which
results in an increase/decrease of the demand, will result in a shift of the demand curve.
The supply of pounds is in essence the UK demand for dollars. As the pound appreciates
($/£T), the costs of US exports become cheaper for UK residents (they demand more US
exports). This results in an increased demand for dollars. If the goods demand response is
sufficiently strong, UK residents have to increase the amount of pounds supplied in the
foreign exchange market. Every factor that increases the demand for US goods and dollars,
will reflect in an increased supply of pounds. The spot exchange rate can be thought of as
being determined by the interaction of the supply and demand for the currency.
1.8 Alternative exchange rate regimes
Under a floating exchange rate regime the authorities do not intervene to buy or sell their
currency in the foreign exchange market. They allow the value of their currency to change
due (adjust in response) to fluctuations in the supply and demand of the currency (= the
essence). In a fixed exchange rate regime, governments can intervene to try and fix the
exchange rate around certain levels. An appreciation might be considered undesirable as it
would hit the economy’s exports, while a depreciation might be considered undesirable since
it would lead to a rise in the cost of imports and endanger the bank’s inflation target. Fixed
exchange rates can be vital for economic stability. A non-sterilized intervention means that
the buying/selling of the pound in the foreign exchange market affects the UK money supply
and interest rates. In a sterilized intervention, authorities will attempt to restore domestic
money supply and interest rates back to their levels before the foreign exchange market
intervention took place.
In this figure, PLN can be seen as $ and euros as £ in our example. So the quantity of pounds
£ and the UK money supply.
The demand shifts to the right. To prevent an appreciation of the £, the Bank of England sells
Q1-Q3 pounds in the foreign exchange market by purchasing US dollars – these £ sales shift
the supply of £ to the right. The exchange rate is at its old level. The reserves of US dollars of
the BoE have increased. The money supply has increased (the amount of pounds in
circulation: M), lowering the UK’s interest rate. Since the sale of pounds has increased the
UK money supply the intervention is of the non-sterilized type. This is a very effective way
of moving exchange rates in the desired direction. However, there is a risk of overshooting
the Bank’s inflation target. In this case, the Bank might try to sell UK Treasury Bills to the
public in an open-market operation that would again reduce the money supply to the original
level. The interest rates would rise again – this would tend to increase the attractiveness of
the pound in the foreign exchange market, increasing the demand. The exchange rate would
increase again. Conclusion: it is highly unlikely that a sterilized foreign exchange market
intervention would be effective. The Central Bank may hope to have a psychological impact
on market participants whilst sticking to its monetary and interest rate targets. There most
likely will only be a limited exchange rate impact since none of the fundamentals change.
1.9 The determination of the forward exchange rate
The forward exchange market is where buyers and sellers agree to exchange currencies at
some specified date in the future. Traditionally, economic agents involved in the forward
exchange market are divided into three groups.
1. Hedgers: agents (usually firms) that enter the forward exchange market to protect
themselves against exchange rate fluctuations which entail exchange rate risk.
Exchange risk is the risk of loss due to adverse exchange rate movements. By
engaging in a forward exchange and fixing the forward exchange rate the trader can
be sure of the amount of £ he will have to pay for the imports ($15,500 in one year’s
time from the USA), and can protect himself against the risk entailed by exchange
rate fluctuations. With a forward exchange rate of $1.55/£1, he will have to pay
£10,000 in one year. The spot exchange rate in one year’s time could be $1.25/£1, in
which case he would otherwise have had to pay £12,400 (without the forward
contract), but now only £10,000. On the other hand, if the rate in one year is $2/£1, he
would have had to pay £7,750 without the forward contract, but of course
£10,000 with the forward contract (so it turns out this was less desirable ex post).
2. Arbitrageurs: agents (usually banks) that aim to make a riskless profit out of
discrepancies between interest rate differentials and what is known as the forward
discount or forward premium. A currency is said to be at a forward premium if the
forward exchange rate quotation for that currency represents an appreciation for that
currency compared to the spot quotation. The forward discount or premium is usually
expressed as a percentage of the spot exchange rate:
Forward discount/premium
Where F is the forward exchange rate quotation and S is the spot exchange rate quotation.
The presence of arbitrageurs ensures that what is known as the covered interest parity
(CIP) condition. The CIP formula is typically used by banks to calculate their forward
exchange quotation.
Where F is the forward exchange rate quotation in foreign currency per unit domestic
currency, S is the spot exchange rate quotation in foreign currency per unit of domestic
currency, r is the one-year domestic interest rate and r∗ is the one-year foreign interest rate.
1. Speculators: agents that hope to make a profit by accepting exchange rate risk.
Speculators engage in the forward exchange market because they believe that the
future spot rate corresponding to the date of the quoted forward exchange rate will be
different from the quoted forward rate. If the one-year forward rate is $1.55/£1, he
may sell £1000 forward, to obtain $1,550. If he believes the spot rate in one year will
be $1.40/£1, then he could change the $1,550 back into pounds at $1.40/£1 which will
yield £1,107.14 (making a profit of £1,107.14 − £1000 = £107.14). If the spot
exchange rate in a year would be $1.80/£1 however, the $1,550 are only worth
£861.11 (a loss of £138.89).
1.11 Conclusions
Although exchange rates may move quite substantially at times, this is not necessarily
disruptive to international trade as companies can protect themselves against exchange risk
by hedging in the forward exchange market.
Chapter 2: The Balance of Payments
2.1 Introduction
A good or bad balance of payments can have an influential effect on the exchange rate and
can lead policy-makers to change the content of their economic policies. Deficits may lead
the government to raise interest rates or to reduce public expenditure in order to reduce
expenditure on imports.
2.2 What is the balance of payments?
The balance of payments is a statistical record of all the economic transactions between
residents of the reporting country and residents of the rest of the world during a given time
period (= criterion for a transaction to be included). It reveals how many goods or services
the country has been exporting and importing and whether the country has been borrowing
from or lending money to the rest of the world. Purchases and sales between residents of the
same country are excluded. The term residents comprises individuals, households, firms and
the public authorities. The subsidiaries of a multinational are treated as being residents in the
country in which they are located, even if their shares are not actually owned by domestic
residents.
2.3 Collection, reporting and presentation of the balance of payments statistics
‘All transactions’ include purchases or sales of goods, services or financial assets such as
bonds, equities and banking transactions. Authorities collect their information from the
customs authorities, surveys of tourist numbers and expenditures, and data on capital inflows
and outflows. Information on government expenditure and receipts with foreign residents is
obtained from local authorities and central government agencies. The statistics are based on
reliable sampling techniques but still the figures provide only an estimate. There is no unique
method governing the presentation of balance of payments statistics and there can be
considerable variations in the presentations of different national authorities. However, the
IMF provides guidelines and publishes the balance of payments statistics of all its member
countries in a standardized format.
2.4 Balance of payments accounting and accounts
The balance of payments always balances: each transaction between a domestic and foreign
resident has two sides to it, a receipt and a payment, and both of these are recorded in the
balance of payments statistics. Plus = each receipt of currency from residents of the rest of
the world. Minus = each payment to residents of the rest of the world. The statistics are
divided into three main sections: the current account (income flows), the capital and financial
account (changes in assets/liabilities in the private and non-central bank public sector) and
the settlements account (changes in assets/liabilities of the central bank).
2.5 An overview of the sub-accounts in the balance of payments
The trade balance (X – M, ‘visible balance’) is the difference between receipts for exports of
goods (credit) and expenditure on imports of goods (debit), which can be visibly seen
crossing frontiers.
1. The current account balance (CA) – the sum of the visible trade balance and the
invisible balance (which shows the difference between revenue received for exports of
services and payments made for imports of services). It also includes receipts of
payments of interest, dividends and profits (rewards for investment in overseas
companies, bonds and equity). Unilateral transfers are payments or receipts for which
there is no corresponding quid pro quo (migrant workers’ remittances to their families
back home, payment of pensions to foreign residents etc.). They can be seen as a fall
in domestic income due to payments to foreigners (debit).
2. The capital and financial account (K or KA)– records transactions concerning the
movement of capital into and out of the country. Capital inflows are, in effect, a
decrease in the country’s holding of foreign assets or an increase in liabilities to
foreigners. They are recorded as a plus, credit, because foreign borrowing is an
export. In contrast, capital leaves the country due to lending, buying of overseas assets
= capital outflow = debit. Capital outflows are, in effect, an increase in the country’s
holding of foreign assets or a decrease in liabilities to foreigners.
3. Official Reserves Account (ORA) / Settlements balance: shows transactions
undertaken by the central bank. This includes (i) rises and falls in the foreign
exchange reserves and (ii) borrowing funds or repayments of loans to international
organizations such as the IMF. Reserves made up of foreign currency assets (Treasury
Bonds) are held primarily to enable the central bank to purchase its own currency
should it wish to prevent it depreciating. If a central bank intervenes in the foreign
exchange market to purchase its currency then its foreign exchange reserves fall and
this is recorded as a plus. Vice versa, the foreign exchange reserves increase (minus
on settlements account) when the central bank sell its own currency. Reserves
increase when the authorities have been purchasing the foreign currency because the
domestic currency is strong – other items in the balance of payments are in surplus, so
reserve increases have to be recorded as a debit to ensure overall balance. However, if
a country has to borrow funds from the IMF then this is an increase in its liabilities
and is recorded as a plus in the settlements account.
So:
There will usually be a discrepancy between the sum of all the items recorded in the balance
of payments, which in theory should sum to zero. To ensure that the credits and debits are
equal it is necessary to incorporate a statistical error. It is impossible to keep track of all
transactions; many statistics are based on sampling estimates so some error is unavoidable.
Some transactions might also be underreported because of a desire to avoid taxes.
Furthermore, some dishonest firms may under- invoice their exports and over-invoice their
imports to artificially deflate their profits. Moreover, there is the problem of leads and lags –
a good is imported but the payment is delayed. This time discrepancy may mean that the two
sides of the transaction are not recorded.
2.6 Recording of transactions in the balance of payments
There are basically 5 types of economic transactions that can take place between domestic
and foreign residents.
1. An exchange of goods/services in return for a financial asset.
2. An exchange of goods/services in return for other goods/services (‘barter’ or
‘countertrade’).
3. An exchange of a financial item in return for a financial item.
4. A transfer of goods or services with no corresponding quid pro quo (i.e. food aid).
5. A transfer of financial assets with no corresponding quid pro quo.
2.7 What is meant by a balance of payments surplus or deficit?
While the overall balance of payments always balances, this does not mean that each of the
individual accounts that make up the balance of payments is necessarily in balance. When
talking about a balance of payments deficit or surplus what is really meant is that a subset of
items in the balance of payments are in surplus or deficit. What really makes a current
account surplus or deficit important is that surplus means that the country as a whole is
earning more than it is spending – it is increasing its stock of claims on the rest of the world
or reducing its indebtedness. The current account is likely to pick up changes in other
economic variables (real exchange rate, domestic and foreign economic growth, relative price
inflation).
The basic balance is the current account plus the net balance on long-term capital flows.
Although the worsening of the basic balance is supposed to be a sign of a worsening
economic situation, having an overall basic balance deficit is not necessarily a bad thing. A
large capital outflow, for example, might yield large future profits, dividends and interest
receipts that will help generate future surpluses on the current account. Furthermore, a current
account deficit which is more than covered by a net capital inflow so that the basic balance is
in surplus could be open to two interpretations:
1. The country has nothing to worry about because it is able to borrow over the long run;
2. The basic balance surplus could also be a problem because the long-term borrowing
will lead to future interest, profits and dividend payments which will worsen the
current account deficit.
The principal problem with the basic balance concerns the classification of short and longterm capital flows. The distinction is often blurred when short-term bonds (shorter than a
year) become renewed or long-term bond can be sold back before maturity. Furthermore,
even though a 5-year maturity bond may only have 6 months left when it is sold again, it is
still classified as long-term.
A country that has a current account deficit but is a net recipient of foreign direct investment
(FDI) could be interpreted as a sign of confidence in the long-term prospects of the economy:
the FDI will increase the country’s capital stock and future export earnings.
The settlements balance
The settlements balance focuses on the operations that the monetary authorities have to
undertake to finance any combined imbalance in the sum of the current account and that of
the financial account. With the settlements concept, the autonomous items are all the current
and financial and capital account transactions including errors, while the accommodating
items are those transactions that the monetary authorities have undertaken as indicated by the
settlements balance. If the sum of the current and capital accounts is negative, the country can
be regarded as having a deficit as this has to be financed by the authorities drawing on their
reserves of foreign currency, borrowing from foreign monetary authorities or the IMF.
If exchange rates are left to float freely, then the official settlements balance will tend to be
zero because the central authorities neither purchase nor sell their currency and so there will
be no changes in their reserves. Sales of currency > purchases < currency depreciates and
vice versa. Under fixed exchange rates the settlement concept is very important because it
shows the amount of pressure on the authorities to devalue or revalue the currency. To avoid a
currency depreciation, the authorities have to sell reserves of foreign currency to purchase the
home currency.
Even in a fixed exchange rate regime the settlements concept ignores the fact that the
authorities have other instruments available with which to defend the exchange rate (capital
controls, interest rates). Furthermore, it does not reveal the real threat to the domestic
currency and official reserves represented by the liquid liabilities held by domestic and
foreign residents that might switch suddenly in currency.
2.8 The net international investment position and the balance of payments
The net international investment position (NIIP) is the difference between a country’s
ownership of foreign financial assets and its financial liabilities to foreign residents (what
foreign residents purchase from the domestic market). Net credit nation = positive NIIP when
the external financial assets are greater than the external financial liabilities. If the country
runs a current account deficit then this will mean it has to be financed by either selling assets
to foreigners or borrowing the funds (which will worsen its NIIP position by making it less
positive or more negative). The NIIP is also affected by valuation changes in the external
financial assets and liabilities of the country. Moreover, fluctuations in the exchange rate
influence the NIIP. The US has a negative NIIP because the value of its foreign assets
measured in US dollars is less than the value of its liabilities measured in US dollars. An
appreciation reduces the value of foreign assets and a depreciation increases the value of
foreign assets (while the liabilities are not directly affected).
A current account deficit has to be financed by either selling assets to foreign residents or
increasing liabilities to foreign residents (both worsening the NIIP). The US’ NIIP figure is
affected by 3 factors:
1. The size of the US current account;
2. Changes in the local currency values of US assets and liabilities – if US holdings of
foreign stocks and bonds rise in price more than foreign holdings of US stocks and
bonds than this helps to improve the US’ NIIP.
3. Changes in the dollar exchange rate – a depreciation of the dollar against the euro will
raise the dollar value of US residents’ holdings of euro- denominated assets and
thereby improve the US’ NIIP.
2.9 Do the United States current account deficits matter?
Moreover, when the income elasticity of demand for imports is high and foreign income
elasticity of demand for US exports is low, this will affect imports and means that if US
economy and the rest of the world grow at the same rate, the CA deficit will continue to
widen unless the exchange rate of the dollar persistently depreciates.
US investments are also less popular, because if the dollar depreciates or US interest rates
rise, then investors could incur great losses.
Others have argued that the world tends to invest heavily in US Treasuries which pay
relatively low yields and the US tends to invest heavily abroad in foreign equities and
companies which tend to generate higher yields over the longer run. So the US debt payments
are on average much lower (US risk-free rate) than the return on its holding of foreign assets.
Several mechanisms could lead to an eventual correction of the US current account deficit:
1. A rise in real US interest rates which would lead to more private savings and less
private investment (slowdown in economy and net imports);
2. A depreciation of the dollar in real trade-weighted terms which over time should
increase US exports and decrease imports;
3. A decrease in the US budget deficit through a mixture of tax rises and/or decrease in
government expenditure (slow down economy, decrease imports); and
4. An increase in economic growth rates in other countries which would increase the
demand for US exports.
Advantage for the USA: its (external) debt is also denominated in dollars, so it can print
money to redeem its debt.
2.10 Some open economy identities
The identity for an open economy is given by:
Where Y is national income, C is domestic consumption, I is domestic investment, G is
government expenditure, X is export expenditure and M is import expenditure.
Disposable income is
Private savings is:
We can obtain a rearrangement of the equation:
where X − M is the current account balance, (S − I) is the net saving of the private sector and
(T − G) is the government surplus/deficit. The current account deficit thus has a counterpart
in either private dissaving (private investment exceeding private saving) and/or a government
deficit (government expenditure exceeding government taxation revenues).
The equation is merely an identity and says nothing about causation.
The equation can once again be rearranged to:
This shows that the equilibrium level of national income is determined where injections
(variables on the left hand side) are equal to leakages (“ on the right hand side).
2.12 Conclusions
Which concept of balance of payments is chosen depends upon the exchange rate regime and
the particular purpose of the analysis being undertaken. It is necessary to bring in a time
dimension when analyzing balance of payments statistics. A deficit is not necessarily a bad
thing if it is likely to be followed by future surpluses. It is necessary to look at the
composition of goods that the country is importing. If they are predominantly consumer
goods, the deficit is more worrying than when the imports are plant and machinery for
generating future exports for example.
We also need to consider whether the country is a net creditor or debtor vis-à-vis the rest of
the world. A current account deficit means that the country concerned is increasing its
indebtedness or reducing its claims on the rest of the world. If the country is a net creditor, it
can usually afford to do this, whereas if it is a net debtor the deficit may be regarded as a
more serious problem.
Furthermore, if a country has a current account deficit, high inflation and low economic
growth, then the balance of payments problem is more worrying than if the deficit is
accompanied by high economic growth and ow inflation.
Chapter 3: Elasticity and Absorption Approaches to the Balance of Payments
3.1 Introduction
We will study the elasticity approach and the absorption approach for investigating the impact
of exchange rate changes on the current account position. It will answer the question: will a
devaluation of the exchange rate lead to a reduction of a current account deficit?
Throughout this chapter the exchange rate is defined as the domestic currency units per unit
of foreign currency, so that a devaluation/depreciation of the currency is represented by a rise
in the exchange rate. (We ignore here unilateral transfer and interest, profit and dividends
effects on the current account balance and focus on exports and imports).
3.2 The elasticity approach to the balance of payments
Elasticity approach: analysis of what happens to the current account balance when a country
devalues its currency. Central message: there are 2 direct effects of a devaluation on the
current account balance, one of which works to reduce a deficit, whilst the other actually
contributes to making the deficit worse than before. Assumptions: (1) supply elasticities for
the domestic export goods and foreign import goods are perfectly elastic > changes in
demand volumes have no effect on prices.
The current account balance is CA = X - M, which can be written more detailed as
Or as in the book: CA = X - SM which can be written more detailed as
Where P represents the domestic price level, Xv (x respectively) is the volume of domestic
exports, Mv (m respectively) is the value of imports, P∗ is the foreign
price level and S is the exchange rate (domestic currency per foreign currency).
Effectively, the foreign price charged of what the domestic country imports from that foreign
country (P∗) times the exchange rate (S) is just the domestic price on imports (P𝑚). So the
formulas are the same.
Using the book’s definitions, CA = X-SM . This equation becomes
Dividing this equation by the change in the exchange rate dS, we obtain:
The price elasticity of demand for exports (𝜂s) = the percentage change in exports over the
percentage change in price (as represented by the percentage change in the exchange rate).
So that:
The price elasticity of demand for imports (𝜂𝑚) = the percentage change in imports over the
percentage change in their price (as represented by the percentage change in the exchange
rate). We place a negative (–) if we wish to express elasticity as a positive number.
This is the Marshall-Lerner condition. Statement: a devaluation will improve the current
account, that is dCA/dS > 0 only if the sum of the foreign elasticity of demand for exports
and the home country elasticity of demand for imports is greater than units, so s + m > 1
If this condition is not met, then a devaluation will lead to a deterioration of the current
account.
There are two effects in play once a currency is devalued (£0.50/$1 > £0.6667/$1):
1. The price effect – exports become cheaper measured in foreign currency. If the
domestic country exports, it earns less of the foreign currency on it. Imports become
more expensive measured in the home currency. Because the domestic currency has
devalued, it is worth less and can buy less of the same product (so more money is
needed for the same product > imports more expensive).
2. The volume effect – the fact that exports become cheaper should encourage an
increased volume of exports, and the fact that imports become more expensive should
lead to a decreased volume of imports.
The net effect depends upon whether the price of volume effect dominates. A devaluation
leads to a current account deficit when the increase in export volumes and decrease in import
volumes are not sufficient to outweigh the fact that less is received for exports and more has
to be paid for imports. A devaluation leads to a current account surplus when the increased
volume of export sales and decreased volume of imports are sufficient to outweigh the price
effects so that the current balance improves.
A more complicated formula can be derived which allows for supply elasticities of exports
and imports of less than infinity. A more complicated condition needs to be satisfied. The
balance of payments will improve following a devaluation if:
Where x is the domestic supply elasticity of the export good and 𝜀𝑚 is the foreign supply
elasticity for its export good (the domestic country’s imports). If the supply price elasticities
of exports and imports are less than infinite, an increase in demand for exports will lead to
some rise in the domestic price of exports which will give an additional boost to export
revenues (when demand is inelastic).
3.3 Empirical evidence on import and export demand elasticities
Empirical estimates of the elasticity of demand for exports and imports are generated.
Elasticity optimists: generally believe that the sum of these two demand elasticities tend to
exceed 1 (unity). Elasticity pessimists: generally believe that these two demand elasticities
sum to less than unity. It was argued that a devaluation may work better for industrialized
countries than for developing ones (dependent upon imports, so price elasticity of demand for
imports is very low). Industrialized countries, however, have to face competitive export
markets and their price elasticity of demand for their exports may be quite elastic. Implication
ML condition: a devaluation might be a cure for some BoP deficits but not for others.
Problems involved in estimating the elasticity of demand: (1) it has been shown that up to a
period of six months, estimated price elasticities are invariably so low that the ML conditions
are not fulfilled. In the longer run, the condition is generally met (there are some exceptions).
We therefore say that the ML conditions may not hold in the short run, but may hold in the
medium to long run. This leads to the J-curve effect.
The underlying idea is that the short-run export volumes and imports volumes do not change
much so that the country receives less export revenue and spends more on imports, leading to
a deterioration in the current balance. However, after some time, export volume starts to
increase and import volumes start to decline, and consequently the current deficit starts to
improve and eventually moves into a surplus.
There are numerous reasons to explain the slow responsiveness of export and import volumes
in the short run:
1. A time lag in consumer responses – switching away from foreign imported goods to
domestically produced goods inevitably takes some time because consumers will be
worried about issues other than the price change, such as the reliability and reputation
of domestic produced goods. Or: foreign consumers do not want to switch to
exporting goods of the devaluing country.
2. A time lag in producer responses – the competitive position of exports has improved,
but production cannot be immediately expanded. Usually, orders are made well in
advance and factories might be reluctant to cancel these contracts. Also, the payments
for many imports will have been hedged against exchange risk in the forward market
and so will be left unaffected by the devaluation.
3. Imperfect competition – Building up a share of foreign markets (as a producer of
goods) can be time consuming and costly business > foreign exporters may be very
reluctant to lose their market share in the devaluing country and might respond to the
loss in their competitiveness by reducing their export prices. The rise in the cost of
imports will therefore be partly offset. These effects rely upon some degree of
imperfect competition which gives foreign firms super-normal profit margins enabling
them to reduce their prices.
3.4 The pass-through effect of a depreciation or appreciation
In the preceding analysis, we have assumed that a 10% depreciation/devaluation will lead to a
rise in the price of imports by 10%. In the real world, the pass-through effect is the extent
to which a 1% depreciation leads to a rise in import prices (and vice versa). If a 10%
depreciation leads to only a 6% rise in import prices, then there is only a partial pass-through
effect, with the elasticity of exchange rate pass-through being 0.6.
In a world of imperfect competition, foreign firms may not be prepared to risk losing market
share following a depreciation > they absorb part of the depreciation by reducing their foreign
currency price of exports. After all, the depreciation might only be temporary.
There is quite a bit of dispersion between different industries with the elasticity of passthrough. As the time horizon increases, however, in all industries the elasticity of passthrough increases and often approaches unity. One of the key factors determining the
elasticity of pass-through is the degree of product differentiation: the greater the product
differentiation, the greater the ability of foreign exporters to raise their prices. This is
presumably because firms in industries where the product is differentiated tend to face more
price-inelastic demand for their product and so are able to pass on price rises with less fear of
losing sales.
To the extent that there is only a partial pass-through effect on the price of imports in the
short run, the effect will be to dampen the size and complicate the dynamics and timing of the
J-curve effect. Imports will not rise in price as much as suggested by the devaluation > import
expenditure is reduced, especially when compared to a situation of complete pass-through.
Chapter 4: Macroeconomic Policy in an Open Economy
4.1 Introduction
In chapter 3 we learned that the ultimate impact of a devaluation will in large part be
dependent upon the economic policies that accompany a devaluation. A fundamental
difference between an open economy and a closed economy is that over time a country has to
ensure that there is an approximate balance in its current account. No country can
continuously build up a stock of net liabilities to the rest of the world by running a continuous
current account deficit. Ensuring a sustainable balance of payments position over time is an
important economic objective to go along with those like high economic growth, low
unemployment and low inflation.
4.2 The problem of internal and external balance
Between 1948 and 1973, a lot of exchange rates were pegged to the US dollar (fixed
exchange rates). Because exchange rates could not be used as a policy instrument, there was a
lot of interest in fiscal and monetary policies as a means of influencing the economy. During
the 1950s and 1960s the principal goal was to achieve full employment for the labor force,
with a stable level of prices – the ‘internal balance’. The second goal was to keep the balance
of payments in balance, so balancing supply and demand for their currency – the ‘external
balance’.
Changing in fiscal and monetary policies, which aim to influence the level of aggregate
demand in the economy, are termed ‘expenditure changing’ policies. In contrast, ‘expenditure
switching’ policies attempt to influence the composition of spending between domestic and
foreign goods, for example a revaluation/devaluation of the exchange rate.
The problem of simultaneously achieving internal and external balance is conceptualized by
the Swan Diagram.
On the x-axis we have the amount of real domestic absorption (domestic demand), which
represents the sum of consumption, investment and government expenditure.
The internal balance (IB) schedule represents combinations of the real exchange rate and
domestic absorption for which the economy has full employment with stable prices. An
appreciation (fall) of the real exchange rate will reduce exports
and increase imports; therefore to maintain full employment it is necessary for there to be an
increase in domestic expenditure. To the right of the IB schedule there are inflationary
pressures in the economy because, for a given exchange rate, domestic expenditure is greater
than what is required to produce full employment and vice versa.
The external balance (EB) schedule shows combinations according to which the economy is
in equilibrium in the current account. Upward sloping: a depreciation (rise) of the exchange
rate will increase exports and reduce imports; to prevent the current account moving into
surplus requires increased domestic expenditure to induce an offsetting increase in imports.
Zone B and E have deflationary pressures and zone C and D inflationary pressures.
A major lesson of this simple model is that the use of one instrument, be it fiscal policy or
devaluation, to achieve two targets, internal and external balance, is most unlikely to be
successful. To move from point B (zone C) to equilibrium, the authorities need to both deflate
the economy and undertake a devaluation by appropriate amounts. The deflation combined
with a devaluation will control inflation and improve the current account so that the two
objectives can be met. Tinbergen: a country requires as many instruments as it has targets.
The Swan Diagram provides a useful conceptual framework for economic policy discussion,
but it is rather simplistic in that the underlying economic relationships are not explicitly
defined.
4.3 The Mundell-Fleming model
Around 1962, Fleming and Mundell incorporated international capital movements into formal
macroeconomic models on the basis of the Keynesian IS-LM framework. They termed this
the
IS- LM-BP analysis (IS = investment-savings, LM = liquidity preference-money, and BP =
balance of payments).
4.7 Equilibrium of the model
The equilibrium point where IS-LM-BP intersect has a certain level of income but this need
not be full employment (= internal equilibrium). If the full employment income level is to the
right of the equilibrium income level, then at the full employment level of income planned
leakages would exceed planned injections. This would imply a buildup of stocks of unsold
goods leading producers to reduce output (to the equilibrium level). The BoP is in
equilibrium because the IS and LM schedules intersect at a point on the BP schedule.
In this case there is a BoP deficit because the BP curve lies to the left of the IS-LM
equilibrium. The income level is too high and/or the interest rate is too low, inducing an
overall balance of payments deficit.
Conversely, when the BP curve lies to the right of the IS-LM equilibrium, there is a BoP
surplus.
4.8 Factors shifting the IS-LM-BP schedules
The IS schedule will shift to the right if:
1. There is an increase in investments (I), government expenditure (G) or exports (X).
Higher injections > requires higher level of national income to induce a matching
increase in leakages in the form of increased savings and imports;
2. There is a depreciation/devaluation of the exchange rate (provided that the MarshallLerner condition holds), because a depreciation (rise) in the exchange rate leads to a
reduction of import expenditure and an increase in export sales > injections exceed
leakages > increased level of income required for equality.
The LM schedule will shift to the right if: (1) there is an increase in the domestic money
supply (for a given rate of interest); the increased supply will only willingly be held if there is
an increase in income > higher transactions demand for money. (2) There is an appreciation
of the exchange rate (decrease) > fall in aggregate price index > fall of price for imports >
real money balances enlarged > resulting fall in demand for money > can only be eliminated
by increasing the transactions demand for money > higher level of income > rightward shift
of the LM curve.
1. An autonomous increase in exports or autonomous decrease in imports >
improvement of current account > requires a right-ward shift of the BP schedule to
induce sufficient increase in imports to maintain balance of payments equilibrium.
2. A depreciation/devaluation > value of exports rises > value of imports declines > only
way to ensure BoP balance is to increase the level of domestic income.
4.9 Internal and external balance
Is it feasible to achieve the twin objectives of internal and external balance by combining
fiscal and monetary policies without the need to adjust the exchange rate?
Monetary policy
Expansionary monetary policy = purchasing bonds from the public (money > public) > price
of bonds increases > money supply expands > fall in domestic interest rate > stimulation of
investment > rise in output > deterioration of current account > increased capital outflows >
BoP deficit.
Fiscal policy
Expansionary fiscal policy = government increases expenditure > pure fiscal policy =
financing this increased expenditure by selling bonds > IS curve shifts to the right through the
government multiplier effect > bond sales depress the bond price > raising domestic interest
rate > will partially offset expansion in output. The precise effect of the fiscal expansion on
the BoP is uncertain: the expansion of output worsens the CA but the rise in interest rates will
improve CA. The money supply is not affected by the expansionary fiscal policy since the
money raised by bond sales is used to finance the increased government expenditure.
Sterilized and non-sterilized invention
With sterilized intervention the authorities offset the money-base implications of their
exchange market interventions to ensure that the changes in reserves due to intervention do
not affect the domestic money base. The policy of non-sterilized intervention allows the
reserve changes to affect the monetary base. Under fixed exchange rate, a monetary
expansion shifts the LM curve to the right. This causes a fall in the interest rate and a rise in
domestic income > BoP deficit since CA and capital account deteriorate > excess supply of
the currency > to maintain fixed exchange rates the authorities have to purchase the home
currency with reserves. This would start to shift the LM curve back. This is non-sterilized. In
a sterilized intervention of reserve changes, the reserve falls reduce the money supply and
this is exactly offset by a further expansion of the money supply so that the LM curve
remains at point LM2. Result: a continuous BoP deficit and a continuous fall in reserves >
only possible in the short run.
4.10 Internal and external balance
under fixed exchange rates
See the figure at the right. A situation
of fixed exchange rate and
unemployment. In point A there is an
external balance, but the income level
is below the full employment level. To
eradicate unemployment, a bondfinanced fiscal expansion can shift the
IS schedule to the right, to point B.
Domestic output is now higher than
the full employment level. The
induced increase in imports move the
CA into deficit, and although the rise
in interest rate attracts some capital
inflow, the BoP is in overall deficit
since the economy is to the right of the
BP schedule. The authorities are
forced to purchase the home currency
in the foreign exchange market. A
contractionary monetary policy is
needed, shifting the LM curve to the
left. This raises interest (to restore BoP equilibrium) and brings income to its full employment
level in point C.
4.11 Internal and external balance
under floating exchange rates
See the figure at the right. Monetary
expansion and exchange rate
adjustments. Initial equilibrium is at
point A. An expansionary monetary
policy shifts the LM curve to the right,
leading to a fall in interest rates and an
increase in income, but a BoP deficit in
point B. The exchange rate is allowed to
depreciate and this shifts IS to the right
and BP to the right. It also leads to a shift
of the LM curve to the left and the
curves intersect at point C. Overall, the
exchange rate has depreciated, the
domestic interest rate has fallen and
income has increased. Lower interest rate
= less capital inflow; and increase in
income worsens CA, but depreciation
improves this in an offsetting fashion.
See the figure down below. Fiscal
expansion and exchange rate adjustments. Crucially depends on the slope of the BP schedule
relative to the LM schedule. In case 1, the BP schedule is steeper than the LM schedule,
which means that capital flows are relatively insensitive to interest rate changes, while
monetary demand is fairly elastic with respect to the interest rate. If the IS curve shifts to the
right from an expansionary fiscal policy, then the induced rise of the domestic interest rate
(improves capital account) and the domestic income (CA deteriorates) has opposing effects
on the BoP. The BoP moves into deficit because capital flows are relatively immobile. This
deficit leads to a depreciation of the exchange rate, which shifts the BP schedule to the right.
We are then in point B. This shifts the Lm curve to the right and the IS schedule even further
to the right, until we are in final equilibrium point C. Hence the deterioration in the BoP
resulting from a rise in real income is offset by a combination of a higher interest rate and an
exchange rate depreciation.
See the figure at the right. If the BP schedule is less steep than the LM schedule, capital flows
are much more responsive to changes in interest rates. With an expansionary fiscal policy,
shifting the IS schedule to the right, the increased capital inflow more than offsets the
deterioration in the CA > BoP in surplus. This induces an appreciation of the exchange rate,
which moves the Lm schedule to the right, the IS schedule back to the left and the BP
schedule upward (to the left). Equilibrium is obtained at a higher level of output, higher
interest rate and an exchange rate appreciation.
In conclusion, a fiscal expansion can, according to the degree of international capital
mobility, lead to either an exchange rate depreciation or appreciation.
4.12 A small open economy with perfect capital mobility
What are the implications of high capital mobility for a small country that has no ability to
influence world interest rates? For such a country, the choice of exchange rate regime would
have radical implications concerning the effectiveness of monetary and concerning the fiscal
policy that influences the level of economic activity. Any attempt to raise the domestic
interest rate leads to a massive capital inflow, pushing up the price of bonds until the interest
rate returns to the world interest rate. The domestic interest rate immediately returns to world
level. The implication is that
the BP schedule becomes
horizontal at the world
interest rate, see the figure at
the right. If the authorities
attempt to raise output by a
monetary expansion the LM
schedule shifts to the right.
There is downward pressure
on the exchange rate
resulting in a massive capital
outflow, meaning that there
is pressure for a devaluation
of the currency. The
authorities have to intervene
in the forex market to
purchase the home currency
with reserves. This leads to a
reduction of the money
supply in hands of private
agents. LM moves back to its
initial position. Hence with
perfect capital mobility and
fixed exchange rates,
monetary policy is
ineffective at influencing
output. By contrast, if there
is a fiscal expansion this
shifts the IS curve to the right > upward pressure > capital inflow > appreciation > prevention
of this > purchase foreign currency held by private agents > increase Lm to the right >
equilibrium at world rate and IS, LM and BP curves. Hence under fixed exchange rates and
perfect capital mobility, an active fiscal policy has the ability to achieve both internal and
external balance.
Floating exchange rates and perfect capital mobility
See the figure at the right. A monetary expansion shifts the LM schedule to the right, leading
to downward pressure > capital outflow > depreciation > increase in exports + reduction of
imports > shifts IS curve to the right and Lm schedule to the left. Clearly with an appropriate
initial monetary expansion the authorities could obtain both internal and external balance by
monetary policy alone. With floating exchange rates and perfect capital mobility however,
fiscal policy is ineffective at influencing real output.
The macroeconomic trilemmaMonetary policy is ineffective at influencing output under fixed
exchange rates, while it alone can influence output under floating exchange rates. Vice versa
for fiscal policy.
The trilemma is that the authorities have to make a choice for two of the three goals. It is also
termed the impossible trinity. This is particularly important for developing countries, many of
which choose to fix their exchange rates, but if they choose to do this then they must either
give up control of their monetary
policy or impose capital controls.
4.13 The principle of effective market classification
By the principle of effective market classification, Mundell stated that ‘policies should be
paired with the objectives on which they have the most influence’. This seems sensible, but
what makes it interesting is the suggestion that if this principle is not adopted, economies
may suffer from cyclical instability. The assignment problem = the problem in determining
which instruments to assign to which targets. Mundell suggested that under fixed exchange
rates monetary policy should be assigned to external balance and fiscal policy to
internal balance. See the figure at the right. Under a fixed exchange rate regime, on the
vertical axis we have monetary policy which is neutral at point NM, but expansionary above
this and vice versa. Similarly, the fiscal policy stance is neutral at point NF, and expansionary
to the right of this and vice versa. The internal balance schedule has a negative slope, because
if we start at full employment, a contractionary monetary policy has to be accompanied by an
expansionary fiscal policy to maintain full employment. To the right of IB there is inflation
and to the left there is deflation. The external balance may have a positive or negative slope,
because it can result in a BoP surplus or deficit. We have drawn it with a negative slope,
meaning that an expansionary fiscal policy causes a net deterioration in the BoP, so monetary
policy has to be contractionary to ensure equilibrium.
The IB schedule is drawn steeper than the EB schedule, which must be the case because a
fiscal expansion which causes a rise in income of x% will cause less of a deterioration in the
BoP than a monetary policy that increases by x%. Hence monetary policy has more effect on
external balance than fiscal policy. Because of that, fiscal policy is relatively more effective
with respect to internal balance. If the exchange rate is fixed then fiscal policy should be
paired with the objective of full employment, whereas if the exchange rate is floating then
one should assign monetary policy. The appropriate pairing of instruments and targets depend
upon the degree of capital mobility, the marginal propensities to save and import, the income
and interest elasticity of demand for money, the price elasticity of demand for imports and
exports, and the responsiveness of investment to interest rate variations.
4.14 Limitations of the Mundell-Fleming Model
A number of criticisms relate to the short-run nature of the model:
1. The Marshall-Lerner condition – in the short run this condition is least likely to be
met.
2. Interaction of stocks and flows – this is ignored. A CA deficit can be financed by a
capital inflow, in the short run, but in the long run this leads to a worsening of CA as
it increases the stock foreign liabilities owed by the country to the rest of the world.
3. Neglect of long-run budget constraints – that govern both the private and public
sector. In the long run, private-sector spending has to equal its disposable income, and
in the absence of money creation, government expenditure has to equal its revenue
from taxation. In the long run, the CA has to be in balance. This implies that the
private sector will realize that increased government expenditure will imply higher
taxation for them in the future. Therefore they will save more.
4. Wealth effects – are left out, but may help restoring the long-run equilibrium. Fall in
foreign assets > decrease in wealth > reduction in import expenditure > reduce CA
deficit.
5. Neglect of supply-side factors – the model concentrates on the demand side of the
economy. The implicit assumption is that supply adjusts in accordance with changes
in demand. The supply curve is horizontal up to full employment, so increases in
aggregate demand do not lead to changes in the domestic price level, rather they are
reflected solely by increases in real output.
6. Treatment of capital flows – a rise in the domestic interest rate leads to a continuous
capital inflow from abroad, however it is unrealistic to expect that this will go on
forever, after a while this will stop. The only way to attract capital then would be to
further increase the interest rate. So a continuous capital inflow to finance its CA
deficit would lead to a continuous increase in the interest rate.
7. Exchange rate expectations – the model implicitly assumes that the expected change
of the exchange rate is zero. This is a less tenable assumption under floating exchange
rates. According to the model a monetary expansion leads to a depreciation of the
currency, but it seems unreasonable to assume that economic agents do not expect a
depreciation as well. To encourage them to hold the currency, a rise in the domestic
interest rate might be needed.
8. Flexibility of policy instruments – it is not so easy to simply adjust monetary and
fiscal policy. The political process means that the degree of flexibility is hard to
achieve.
4.15 Conclusions
While fiscal/monetary policy may be useful in achieving full employment, they will also have
important implications for the balance of payments and the exchange rate. Important lesson:
you need as many independent policy instruments as you have targets. Nevertheless, policymakers still have a major policy problem in deciding which instrument to assign to which
target. An incorrect assignment may provoke rather than limit instability in the economy. In
the real world only limited information is known, there are time-lag problems and continuous
economic shocks etc.
Chapter 6: Purchasing Power Parity Theory and Floating Exchange Rate Experience
6.1 Introduction
PPP theory provides a point of reference for the long-run exchange rate and is essential to the
study of international finance.
6.2 PPP theory and the law of one price
The basic concept of PPP theory is that arbitrage forces will lead to the equalization of goods
prices internationally, once the prices of goods are measured in the same currency. It
represents an application of the law of one price. The law of one price simply states that, in
the presence of a competitive market structure and the absence of transport costs and other
barriers to trade, identical products which are sold in different markets will sell at the same
price when expressed in terms of a common currency. The law of one price is based on the
idea of perfect goods arbitrage, which occurs where economic agents exploit price differences
so as to provide a riskless profit. If there is a mispricing in the exchange rate, and therefore an
arbitrage opportunity, this will be exploited and such a process continues until the exchange
rate is at the point where arbitrage profit opportunities are eliminated. PPP argues that the
exchange rate must adjust to ensure that the law of one price, which applies only to individual
goods, also holds internationally for identical bundles of goods.
6.3 Absolute and relative PPP
Absolute PPP – has a strict interpretation of the law of one price. It holds that if one takes a
bundle of goods in one country and compares the price of that bundle with an identical
bundle of goods sold in a foreign country, converted by the exchange rate into a common
currency of measurement, then the prices will be equal. It can be stated as: s= P/P* where s
is the exchange rate, P is the price of a bundle of goods expressed in the domestic currency,
and P∗ is the price of an identical bundle of goods in the foreign country expressed in terms
of the foreign currency.
Relative PPP –The absolute version of PPP is unlikely to hold precisely because of the
existence of transport costs, imperfect information and the distorting effects of tariff and nontariff barriers to trade. The relative PPP argues that the exchange rate will adjust to the
amount of the inflation differential between two economies. %∆s = %∆P - %∆P* where %∆P
is the inflation rate and %∆P* is the foreign inflation rate. If for example the UK inflation
rate is 10% and the US inflation rate is 4%, then the pounds per dollar exchange rate should
be expected to depreciate by approximately 6%.
6.4 A generalized version of PPP
PT = SPT* where S is the exchange rate, PT is the price of traded goods in the domestic
country measured in terms of the domestic currency and PT* is the price of traded goods in
the foreign country measured in terms of the foreign currency.
The aggregate price index (PI) for the domestic economy is made up of a weighted average of
the price of both tradable (PT) and non-tradable goods (PN), priced in the domestic currency.
where is the proportion of non-traded goods in the domestic price index. The same holds for
the foreign aggregate price index:
Where is the proportion of non-traded goods in the foreign price index. Combining these
equations, we obtain:
6.5 Measurement problems in testing for PPP
There are some practical problems involved in testing for PPP. It is not clear whether or not
the PPP theory is supposed to be applicable to both traded goods and/or non-traded goods.
Some argue that the distinction between traded and non-traded goods is fuzzy and that there
are some mechanisms linking both goods prices (in the form of inputs). If the theory is
supposed to be applied only to traded goods, then the price index needs to be made up of
traded goods only. Otherwise a more general price index should be employed. However,
another problem regardless of which price index is used, is that different national price
indexes typically attach different weights to different classes of goods. Finally, a statistical
problem is the base period for testing. There are diverging views over the time span during
which PPP can be expected to hold.
6.6 Empirical evidence on PPP
Graphical evidence on PPP
If we examine the actual exchange rate and the exchange rate that would have maintained
PPP, we see that the actual exchange rate has diverged considerably. PPP does not at all do
well in tracking the dollar-pound rate. For the Deutschmark-dollar rate, the dollar is generally
overvalued in relation to PPP (Deutschmark undervalued). Again with the yen- dollar there
are sustained and market departures from PPP. For the lira, the French franc and the pound
against the Deutschmark, the plots reveal that, although there are deviations from PPP, the
order of magnitude is much smaller than the others discussed before. Transports costs and
trade barriers are small because of their geographical proximity and membership of the EU >
this facilitates goods-market arbitrage that PPP is heavily dependent on. Finally, the dollareuro parity shows substantial and persistent departures from PPP. It is noticeable that
although the exchange rate is frequently far from PPP, it does have a tendency to go back
towards the PPP rate over the longer run.
Econometric evidence
We can test PPP by use of a regression analysis. Hypotheses:
Here, st= log of the domestic exchange rate, Pt= log of domestic tradable goods prices, Pt∗=
log of foreign tradable goods prices.
In both cases, for PPP to hold the regression, estimates would yield 𝑎1 = o and 𝑎2 = 1. The
price and exchange rate variables are put into log form because the change in the log of a
variable approximates to the percentage change in the variable. The regression estimates
provide additional support for the graphical analysis in the case of the relative PPP version.
𝑎2 tends to be lower than 1 and not significantly different than 0 > leading to a rejection of
PPP. All currencies (except the dollar) perform better in PPP tests against the Deutschmark
than they do against the dollar. The results are mixed: the coefficient 𝑎2 is all right in some
sub-periods but not in others, and it is frequently not significantly different from 0.
The graphical and econometric evidence shows that for some rates the deviations from PPP
are both substantial and prolonged. Furthermore, estimates of 𝑎2 differ substantially in the
sub-periods and are often not significantly different from 0.
6.7 Summary of the empirical evidence of PPP
1. PPP performs better for countries that are close to one another and where trade
linkages are high.
2. There have been both prolonged and substantial deviations from PPP which have
frequently been reversed.
3. Exchange rates have been much more volatile than the corresponding national price
levels (contrary to PPP where exchange rates are only supposed to be as volatile as
prices).
4. PPP holds better in the long run than in the short run.
5. Currencies of countries that had very high inflation rates relative to trading partners,
experienced rapid depreciations reflecting their relatively high inflation rates. PPP =
dominant force in determining their exchange rates during that period.
6. Overall, PPP holds better for traded goods than non-traded goods.
7. Half-life = the time it takes in years to correct 50% of a deviation from PPP. This was
shown to be about three to five years.
8. PPP is much less likely to hold if one uses consumer price indices (CPI)
6.8 Explaining the poor performance of PPP theory
1. Statistical problems – comparing identical baskets of goods in two economies >
countries usually attach different weights to various categories of goods and services
when constructing their price indexes = difficult to compare when testing PPP. This
difference is greater for developing vs. developed countries.
2. Transport costs and trade impediments – deviations might be explained by the
existence of transport costs and trade impediments – however, since transport costs
and trade barriers do not change dramatically over time they are not sufficient
explanations for the failure of the relative versions of PPP.
3. Imperfect competition – PPP needs sufficient competition to prevent the price of a
good in one country majorly exceeding that of another. Conditions necessary for
successful price discrimination are for most part more likely to hold between rather
than within countries.
4. Differences between capital and goods markets – PPP is based upon the concept of
goods arbitrage and does not say anything about capital movements. Prolonged
deviations can persist when capital markets are highly integrated and goods market
prices adjust slowly. Prices are fixed in the short run, while the exchange rate adjusts
quickly to new information and changes in economic policy.
5. Productivity differentials – when prices of similar baskets of both traded and nontraded goods are converted into a common currency, the aggregate price indexes tend
to be higher in rich countries than in poor countries. An explanation of the lower
relative price in poor countries is put forward by Balassa and Samuelson. Main point:
lower price is due to lower labor productivity in the tradables sector compared to
developed countries.
6.9 The Balassa-Samuelson model
Balassa and Samuelson argue that labor productivity in rich countries is higher than in poor
countries. The productivity differential occurs predominantly in the tradables rather than the
non-tradables sector.
Wages are assumed to be the same in the tradables and non-tradables sector within each
economy and positively related to productivity.
where PN = non-tradables prices, PT is traded goods prices, QT is output per worker in the
tradables and QN non-tradables sector.
Wage rates are the same in both industries:
Productivity is higher in the rich economy’s tradables sector, but the non-tradables sector
productivity is the same for both countries:
PPP is assumed to hold only for traded goods:
The price ratio of traded to non-traded goods is given by two formulas:
Since here is higher productivity in the rich economy’s tradables sector, then the relative
price of non-tradables to tradables will be higher in the rich country, so 𝜋∗ > 𝜋.
Since PPP holds for the tradables sector, resulting in PT = SPT* the denominator of the last
two equations are the same. Since 𝜋∗ > 𝜋, the price of non-tradables in the rich economy
exceeds the price of non-tradables in the developing country, that is SPN* > PN that is: PPP
does not work for non-traded goods. Low wages in the developing country, due to low
productivity in its traded sector, also lead to relatively low price for its non-traded goods even
though productivity in this sector is the same as in developed countries. Exchange rate =
higher in developed countries. The model helps explain why the ratio of non-traded to traded
prices tends to be higher in developed economies than in developing economies.
PPP based on tradable goods alone will undervalue the purchasing power and living standards
of people in poor countries because they can purchase more non-traded goods per dollar than
people in rich countries. Rather, the proportion of poor country expenditure on non-tradables
should be valued at rich country non-tradables prices, thereby raising the value of ‘poor
country’ incomes. The Balassa-Samuelson model cannot explain the failure of PPP to hold for
traded goods.
6.10 Per capita income levels, the relative scopes of economies and the importance of
PPP estimates
The World Bank keeps track of income level per capita of developing countries (which
countries do policy-makers wish to direct aid towards and to provide access to cheap finance
for developmental purposes). The fact that PPP tends not to hold, especially between
developed and developing nations, is of considerable importance in this respect. In particular
the price of non-tradable goods and services in developing countries is significantly lower
than in developed countries. In particular, the exchange rates of developing countries tend to
be noticeably undervalued in terms of purchasing power for goods and services. Suppose the
exchange rate was 630 renminbi for $100, but if you convert the dollars into renminbi you are
able to buy twice as many goods and services in China than in the USA. The appropriate PPP
exchange rate in terms of goods and services would then be 630/2 = 315 renminbi per 100
dollar. For this amount you can buy the same bundle of goods in China as well as in the US.
The GDP per capita based on PPP is a more reliable guide (albeit highly imperfect!) to
relative living standards in the two countries than using the market exchange rate which does
not reflect PPP. Not only do PPP adjustments make a significant difference to GDP per capita
estimates, they also make a big difference to the importance of the relative scope of different
economies.
6.11 Conclusions
At the time of the adoption of floating exchange rates is was widely believed that they would
adjust in line with changes in national price levels as predicted by PPP theory. However, there
can be substantial and prolonged deviations from PPP. Explanations do not apply to capital
movements (which have grown enormously after WWII). Capital movements influence
agents’ expectations about the future > exchange rates change regardless of whether goods
prices are changing. Finally, over or undervaluation of currencies in relation to PPP induce
changes in current-account positions which will eventually lead to exchange rate changes.
Deviations from PPP have a habit of reversing themselves in the longer run.
Chapter 7: Modern Models of Exchange Rate Determination
7.1 Introduction
The PPP theory is very much concerned with goods arbitrage but has nothing to say about
capital movements internationally. Speculators will tend to move their money between
currencies based on the expected rate of return of one currency compared to another.
Expectations are crucial – if a currency is expected to depreciate, then agents will tend to
switch from that currency to those currencies that they expect to appreciate.
The common aspect of the models that we will analyze in this chapter is that they all
emphasize the important role of relative money supplies in explaining the exchange rate. The
monetary models argue that exchange rate movements can be explained by changes in the
supply and demand for national money stocks. We will analyze three models:
1. flexible-price monetary model,
2. sticky-price monetary model and
3. real-interest-rate-differential model. These models make an assumption that domestic
and foreign bonds are perfect substitutes.
7.2 Uncovered interest rate parity
The exchange rate can be viewed as a relative asset price, with the fundamental characteristic
that its present value will be largely influenced by its expected rate of return. If you choose
between UK and US bonds with similar risk and maturity and you can switch between them
instantaneously, there will be two factors that investors will bear in mind in their
consideration: (i) the rates of interest on UK bonds and US bonds, and (ii) what they expect
to happen to the pound-dollar exchange rate. The international bond market is in equilibrium
if: Es=ruk- rus , where Eṡ is the expected rate of depreciation of the exchange rate of the
pound (£/$). ruk is the UK interest rate and rus is the US interest rate. This is the uncovered
interest parity condition (UIP). UIP states that the expected rate of depreciation of the pound
against the dollar is equal to the interest rate differential between UK and US bonds. If ruk
= 1o% and rus = 4%, then on average international investors apparently expect the pound to
depreciate by 6% (If the exchange rate now is £0.50/$1, in one year it will be £1.50/$1 × 1.06
= £0.53/$1). The UIP condition implies that the expected rate of returns on domestic and
foreign bonds are equal. For the UIP condition to hold continuously, it is crucially required
that capital is perfectly mobile so that investors can instantly alter the composition of their
international investment. It also assumes equal riskiness of domestic and foreign bonds (and
also that investors have the same risk adversity). When the UIP conditions are met (on a
continuous basis), UK and US bonds are said to be perfect substitutes.
7.3 The monetary models of exchange rate determination
The common characteristic of the three models we will analyze is that they use supply and
demand for money as the key determinants of exchange rates. All the models employ the UIP
condition. However, the flexible-price model argues that all prices in the economy are
perfectly flexible both upwards and downwards in both the short and long run (effect of
inflationary expectations incorporated). The sticky price model however, argues that in the
short run wages and prices tend to be stick and only the exchange rate changes in response to
changes in economic policy (inflationary expectations not explicitly dealt with). The realinterest-rate differential model combines the role of inflationary expectations of the flexibleprice monetary model with the sticky prices of the Dornbusch model.
7.4 The flexible-price monetary model
The flexible-price model assumes that PPP holds continuously. The model introduces relative
money stocks into the picture as determinants of the relative prices, which in turn determine
the exchange rate.
We assume that there is a conventional money demand function so that the money market
equilibrium is:
where m is the log of the domestic money stock, p is the log of the domestic price level, y is
the log of domestic real income and r is the nominal domestic interest rate.
Foreign money demand is:
where m* is the log of the foreign nominal money stock, p* is the log of the foreign price
level, y* is the log of foreign real income and r* is the foreign interest rate.
It assumes that PPP holds continuously, expressed as:
where s is the log of the exchange rate. Assuming that domestic and foreign bonds are perfect
substitutes, the uncovered interest parity condition holds:
If we rearrange the domestic and foreign demand equations to give solutions for the domestic
and foreign price levels, respectively, we get:
and
Substituting these equations in the logarithmic exchange rate formula (s) we get:
So, the sport exchange rate on the left-hand side is determined by the explanatory variables
on the right-hand side. This equation predicts the following:
1. Relative money supplies affect exchange rates - % increase in the home money supply
leads to an equivalent depreciation of the currency (because increase in home money
supply > immediate equivalent increase in prices > PPP holds > equivalent
depreciation of currency). The opposite is true for a % increase in the foreign money
supply.
2. Relative levels of national income influence exchange rates – if domestic income
were to rise, this increases the transactions demand for money, and the increased
demand for money means that if the money stock and interest rates are held constant
the increased demand for real balances can only come about through a fall in domestic
prices (the currency then needs to appreciate to maintain PPP).
3. Relative interest rates affect exchange rates – an increase in the domestic interest rate
leads to a depreciation of the domestic currency (because increased domestic interest
rate > fall in demand for money > depreciation of domestic currency).
The nominal interest rate is:
where 𝑖 is the real interest rate (!) and Pė is the expected rate of price inflation. The foreign
nominal interest rate is given by:
Assuming that 𝑖 = 𝑖∗ and that the real interest rate is constant, an increase in the domestic
nominal interest rate is due to an increase in the domestic price inflation expectations. Such
increased inflation expectations lead to a decreased demand for money and an increased
expenditure on goods, which in turn leads to a rise in domestic price > requires a depreciation
of the currency to maintain PPP.
The exchange rate equation can be rewritten as:
The flexible price monetary model is based upon the premise that all prices in an economy
are fully flexible and that bonds are perfect substitutes. Despite its shortcomings and reliance
on PPP, the model is an important addition to exchange rate theory because it introduces the
role of monetary supplies, inflationary expectations and economic growth.
7.5 The Dornbusch sticky-price monetarist model
Deficiency of flexible-price monetarist model: it assumes that PPP continuously holds and
that prices are as flexible upwards and downwards as exchange rates. The model does not
explain does not explain prolonged departures from PPP since floating exchange rates are
adopted. A model that can explain this is the sticky-price monetarist model: prices in the
goods market and wages in the labor market are determined in sticky-price markets and only
tend to change slowly over time in response to various shocks such as changes in the money
supply. Prices and wages are especially resistant to downward pressure.
7.6 A simple explanation of the Dornbusch model
Assumption of the Dornbusch model: UIP holds continuously, i.e. if the domestic interest rate
is lower than the foreign interest rate then there needs to be an equivalent expected rate of
appreciation of the domestic currency to compensate for the lower interest rate.
See the figure at the right. Imagine that the economy is initially in full equilibrium with a
domestic interest rate equal to the world interest rate (no expected appreciation or
depreciation of the currency). Suppose that the authorities unexpectedly expand the domestic
money supply by 20%. In the long run the exchange rate will be constant so that expected
depreciation will be zero again. UIP implies then that the interest rate is again the world
interest rate. Because of this money market equilibrium, the prices will rise. Because the long
run goods market is in equilibrium and potential output does not change, goods market
equilibrium requires that the initial demand is restored, which means that the real exchange
rate is back at its starting value. The 20% rise in domestic prices is offset by 20%
depreciation of the domestic currency.
However, in the short run, domestic prices are sticky. The unexpected increase in the
domestic money supply will mean that there is excess supply of money at the current price
level and that this will only hold if the domestic interest rate falls. Since the domestic interest
rate will then be lower than the world interest rate and the domestic currency is expected to
depreciate, speculators will invest abroad. This depreciation continues until the home
currency has become so cheap that investors expect an appreciation that compensates for the
low domestic interest rate. For this reason, the domestic currency jump depreciates after a
while, but first overshooting its long-run equilibrium value. This is necessary otherwise an
expected appreciation would not be there to compensate for the lower rate of interest on
domestic bonds.
As a result of the fall in the domestic interest rate and the depreciation of the domestic
currency, there is an increase in the demand for domestic goods. Output is assumed to be
fixed, so that demand excess starts to drive up the prices. The increased demand for domestic
goods by foreigners leads to an exchange rate appreciation (thus the expected appreciation is
matched by an actual appreciation). At the same time, the higher price will lead to an increase
in domestic money demand and a rise in the domestic interest rate to maintain money-market
equilibrium. The domestic interest rate returns to its normal level. The change in prices
reflects one-to-one the increase in the money supply.
7.7 A formal explanation of the Dornbusch model
There are three markets.
(1) Money market equilibrium becomes:
where m is the log of the domestic money stock, p is the log of the domestic price level, y is
the log of domestic real income and r is the nominal domestic interest rate.
(2) The international bond market equilibrium:
where Eṡ is the expected depreciation of the home currency - assumptions here: UIP
condition holds, and domestic and foreign bonds are perfect substitutes.
(3) The goods market equilibrium:
where d is the log of aggregate demand and y is the log of domestic real income - no PPP!
Furthermore, the model allows for departures of the exchange rate from its long-run
equilibrium value. So we specify an equation for the (regressive) expected rate of change of
the exchange rate.
is the log of the long-run equilibrium exchange rate. So the expected depreciation of a
currency is determined by the speed of adjustment and the gap between the current exchange
rate and its long-run equilibrium value.
7.8 Derivation of the goods-market equilibrium schedule
The goods-market equilibrium schedule (GG) shows price and demand for goods. The model
assumes that the rate of price inflation in the model is determined by the gap between
aggregate demand and aggregate supply:
where ṗ is the rate of domestic price inflation, 𝜋 is the speed of adjustment of prices and d is
the log of aggregate demand and y the log of real income. Aggregate demand is:
where
is 0 in this special case.
here is exogenous expenditure. Substituting this equation for d in the price inflation equation,
we get:
Along the goods-market equilibrium schedule (GG) the equality of demand and supply for
money means that there is zero inflation so ṗ = o. To find the slope of the goods-market
schedule we must substitute a solution for r in the equation:
By setting this equation to zero, we find that the slope of the GG line is:
The slope is less than 1. The rationale behind the GG schedule is that a depreciation (rise) of
the exchange rate leads to an increased demand of exports, which can only be offset by a rise
in the domestic price level, which negates the competitive advantage of the depreciation.
However, because the rise in the price level increases money demand, it is accompanied by a
rise in interest rates, which further reduces demand. So the % depreciation of the exchange
rate has to be higher than the % rise in the price level, to keep aggregate demand in line with
aggregate supply. To the left of GG, there is excess supply and to the right there is excess
demand.
7.9 Derivation of the money-market equilibrium schedule
In the money market schedule we solve for the domestic interest rate:
So:
The slope of the money market schedule is given by:
For a given money stock a fall in the price level implies a relatively high real money stock,
and high real money balances will only be willingly held if the domestic interest rate falls,
which requires an expected appreciation of the currency to compensate the holders of the
domestic currency. Exchange rate expectations = regressive, so expected appreciation can
only occur if the exchange rate depreciates.
< Equilibrium in the model occurs when the goods and money and international bond
markets are in equilibrium. Where they intersect, there is ‘asset-market equilibrium’.
7.10 A money supply expansion and
exchange rate ‘overshooting’
Initially the economy is in equilibrium.
Authorities unexpectedly expand the money supply by x%. In the long run, domestic prices
will rise by the same percentage as the rise in the money stock, so a rise in p of x%. This in
turn requires a depreciation of the exchange rate by x% (which gives the long-run exchange
rate).
In the short run however, the monetary expansion leads to a shift to the right of the MB curve
(red arrow). In the short run, prices are sticky and money markets are in continuous
equilibrium, as indicated by the UIP condition. So we end up on the dotted red line but at the
same price (see horizontal purple arrow). The price level remains the same, which translates
into a jump in the exchange rate (purple arrow as well). This is because the money supply
expansion creates an excess of real money balances which (given fixed output level) are only
willingly held at a lower domestic interest rate. According to UIP, a fall in the domestic
interest rate means that international investors will require an expected appreciation of the
domestic currency to compensate for the lower domestic interest rate. This is only possible if
the exchange rate depreciation in the short run exceeds the required long-run depreciation.
The short-run equilibrium exceeds the long-run equilibrium rate, which is known as
‘overshooting’. The undervaluation of the currency will mean that domestic goods become
relatively cheap as compared to foreign goods, and this leads to a substitution of world
demand in favor of domestic goods = ‘arbitrage effect’. This drives up the domestic price
level and appreciates the exchange rate until the long-run equilibrium is reached. (During this
transition, the rise in the price level reduces real money balances, requiring a rise in the
domestic interest rate until the original interest rate is restored at the long run price level). So,
finally we move into equilibrium again (purple dot), as we move along the dotted red MB
line. Prices have increased (long-run) and the exchange rate is at its long-run equilibrium
value.
7.11 Importance of the sticky-price monetary model
The major innovation of the sticky-price monetary model is its emphasis on capital-market
rather than goods-market (only in medium/long run) arbitrage as being the major determinant
of exchange rates in the short run. Desire of investors to equalize expected yields tlo their
international portfolios = determinant of short-run exchange rate. The model explains
exchange rate movements as the outcome of a rational foreign exchange market that produces
an exchange rate that deviates from PPP according to economic fundamentals and not in
isolation from them (so not because of irrational speculation). It is also an appealing
explanation of why exchange rate movements have been large relative to movements in
international prices and changes in international money stocks.
7.13 Implications of the monetary views of exchange rate determination
Monetary policy is the only predictable and effective means of influencing the exchange rate.
Because domestic and foreign bonds are substitutes, there is no distinction between the
effects of an open market operation (OMO) and a foreign exchange market operation (FXO).
Expansionary OMO = purchase of domestic treasuries. Expansionary FXO = purchase of
foreign bonds. What matters for the exchange rate is the supply of money in relation to the
demand for it. A sterilized FXO will have no effects on the exchange rate. An SFXO is an
exchange of domestic for foreign bonds that leaves the supply of money in relation to the
demand for it unaffected.
In the flexible-price monetarist model, while the authorities can influence the nominal
exchange in a predictable fashion by monetary policy but not the real exchange rate (or other
real variables). If there is a x% increase in the money supply this will lead to a x%
depreciation of the home currency and a simultaneous x% increase in the price level and
wages. In contrast, within the context of the sticky-price monetarist approach, the authorities
can exploit the finite speed of adjustment of domestic markets to influence the real exchange
rate in the short run, provided that real output is fixed. There could be an unexpected increase
in the domestic money stock, and then domestic prices that are sticky will lead to a
depreciation of the real exchange rate. Therefore sometimes the exchange rate is ‘overshot’.
For this reason, some have proposed ‘gradualism’ in the implementation of monetary policy.
Claim: economic agents in the goods and labor markets take time to adjust to a new monetary
policy regime because they need convincing that the authorities mean what they say. If
authorities implement their policy of restraint gradually, then economic agents will have time
to observe that the authorities are implementing their stated policy and that wage behavior
will then adjust without the high cost imposed upon the economy of overshooting.
In the long run, the authorities should abandon any attempt to influence the real exchange rate
because it is determined by real and not monetary factors. Thus in the long run (short run in
the flexible-price version) the authorities should direct exchange rate management at
stabilizing the domestic price level. The authorities should not seek to stabilize the nominal
exchange rate by monetary policy because this may involve destabilizing the domestic price
level if the foreign authorities are not pursuing stable monetary policies.
7.17 Conclusions
Common characteristic of the monetary models of exchange rate determination = the money
supply in relation to money demand in both the home and foreign countries matters for the
exchange rate. The exchange rate is the relative price of two national moneys and is
consequently a monetary phenomenon.
Furthermore, the flexible-price monetary model assumes PPP holds continuously and
maintains that the price level adjusts instantaneously to changes in the supply and demand for
money. Changes in real income and inflation expectations induce changes in the exchange
rate because they affect the demand for money. In the sticky-price monetary model PPP can
deviate in the short run but will reassert itself in the long run. Exchange rates can become
misaligned in relation to PPP because of the phenomenon of exchange rate overshooting,
while instability in monetary policies can result in even greater instability in exchange rates.
Divergences from PPP in the short run can be explained by rational speculation (not
necessarily irrational).
Drawbacks:
1. No explicit role for the current account to influence the exchange rate.
2. Domestic and foreign bonds are regarded as perfect substitutes (equally risky – so no
risk perceptions). The portfolio balance model does have a role for both of these
factors. However, it does not identify a precise reason for perceived differences in
risk. Reducing perceived risks may be important for reducing exchange rate
fluctuations.
Chapter 8: The Portfolio Balance Model
8.1 Introduction
Our monetary models of exchange rate determination have the critical assumption that
domestic and foreign bonds are perfect substitutes, and therefore have equal expected yields.
However, the portfolio balance model allows for the possibility that international investors
may regard domestic and foreign bonds as having different characteristics other than their
currency of denomination.
Operations that influence the exchange rate affect the composition of domestic and foreign
bonds in agents’ portfolios in different ways – therefore it is important to allow for domestic
and foreign bonds to have different characteristics. We examine three operations:
1. An open market operation (OMO): an exchange of domestic money for domestic
bonds or vice versa.
2. A foreign exchange operation (FXO), non-sterilized: an exchange of domestic
money for foreign bonds (expansionary) or vice versa (contractionary).
3. A sterilized foreign exchange operation (SFXO): an exchange of domestic bonds
for foreign bonds or vice versa (domestic money base is unchanged).
The SFXO represents the difference between OMO and FXO. Because of a contractionaryn
expansionary FXO, the public holds more money and less foreign bonds. Then a
contractionary monetary policy could be conducted by selling domestic bonds to the public
so that the money held by the public returns to its original level. This is a sterilization
approach. The net effect is that the public holds less foreign bonds and more domestic bonds
while the money supply remains unchanged.
In monetary models there is no difference in the exchange rate and the interest rate effects of
an FXO or OMO that change the money supply by like amounts. Reason: there is no
distinction between domestic and foreign bonds.
8.2 The concept of a risk premium
The concept of risk premium is crucial to the portfolio balance approach. Investors no longer
regard domestic and foreign bonds as perfect substitutes (so expected returns are no longer
equal). The UIP condition no longer holds. The risk premium is the additional expected return
on the relatively risky bond as compared to the less risky bond. For a risk premium to exist
three conditions must be fulfilled:
1. There must be perceived differences in risks between domestic and foreign bonds –
the essence of a risky asset being that its expected real rate of return is uncertain.
2. There has to be risk-aversion on the part of economic agents to the perceived
differences in risk – investors will only be prepared to take on increased risk if there is
a sufficient increase in expected real returns to compensate.
3. There is a theoretical portfolio known as the risk-minimizing portfolio which would
minimize the risks facing private agents. There must be a difference between the riskminimizing portfolio and the actual portfolio.
If all three conditions above are met, then the UIP condition will not hold due to the existence
of a risk premium which represents the compensation required by private agents for accepting
risk exposure above the minimum possible:
. Here, Eṡ is the expected rate of depreciation of domestic currency defined as domestic
currency units per unit of foreign currency. It is important to note here that RP is the risk
premium required on domestic bonds, so this can be either positive or negative. A 1%
positive risk premium on the domestic currency is a negative 1% risk premium on the foreign
currency.
8.3 Different types of risk
Assumptions:
1. investors are rational,
2. investors maximize their expected utility which is a positive function of expected real
returns and a negative function of the perceived level of risk.
Risky asset: an asset whose expected real rate of return is uncertain. The value of return in
terms of purchasing power cannot be determined with certainty.
Currency risks
1. Inflation risk – inflation rates are uncertain. PPP suggests that the real interest rate is
uncertain because inflation is uncertain. This also holds for foreign countries. If
inflation increases and the expected real rate of return on domestic bonds decreases,
this does not increase the expected real rate on foreign bonds, because the currency
will depreciate by the same amount as the expected inflation rate (so it does not affect
foreign return).
2. Exchange risk – If PPP holds continuously, then inflation risk would be the sole
currency risk facing international investors. However, if we reject PPP, we also have
to take into account deviations from PPP when calculating the expected real rate of
return on domestic and foreign bonds during the holding period. When holding a
foreign bond, the expected real rate of return is the expected deviation of exchange
rate. Fluctuations in the exchange rate that cause deviations from PPP constitute a risk
specific to foreign investments which is called exchange risk. Exchange rate changes
only cause exchange risk to the extent that they represent deviations from PPP.
Country risks
1. Exchange control risk – country risk whereby investors face uncertain real rates of
return (on domestic and foreign bonds) due to the risk of the imposition of a tax on
the interest element during the holding period
2. Default risk – A government refuses to pay the interest and/or the principal on bonds
issued by them and denominated in a foreign currency (governments cannot default
on bonds issued in its own currency > print money).
3. Political risk – the danger that investors face because the political environment in a
country could cause them to lose their investments, or to find costly restrictions
imposed on how they may manipulate their investments.
Chapter 10: Fixed, Floating and Managed Exchange Rates
10.1 Introduction
We will examine the traditional and recent arguments for and against fixed and floating
exchange rates. Although exchange rates have been allowed to float since 1973, authorities
have frequently intervened in the foreign exchange market in a bid to influence the exchange
rate at which their currency is traded, hence the term ‘managed floating’.
10.2 The case for fixed exchange rates
NB: arguments against floating exchange rates are not necessarily arguments in favor of fixed
rates: they may well constitute arguments for some degree of exchange rate management
rather than for fixed parities.
1. Fixed exchange rates promote international trade and investment - Fixed parities
provide, just as a single currency, the best means of promoting international trade and
investment at the international level. Exchange rate fluctuations cause additional
uncertainty and risk in international economic transactions and inhibit the growth and
development of such transactions.
2. Fixed exchange rates provide discipline for macroeconomic policies – the
commitment to a fixed exchange rate regime provides a degree of discipline to
domestic macroeconomic policy, because the pursuit of reckless macroeconomic
policies (such as excessive monetary growth) will lead to pressure for a devaluation of
the currency necessitating intervention by the authorities to defend their currency and
a fall in their reserves. Such an unpleasant scenario should encourage governments to
resist adopting unsound expansionary macroeconomic policies.
3. Fixed exchange rates promote international cooperation and coordination – countries
that agree to peg their exchange rates generally have to agree on measures to be
undertaken when the agreed exchange rate parity comes under pressure. At a
minimum, fixed exchange rates require an agreement to avoid conflicting exchange
rate targets, ruling out the dangers of competitive devaluation scenarios. A stable
environment is the result.
4. Speculation under floating rates is likely to be destabilizing – this can produce an
exchange rate that is suboptimal from the viewpoint of resource allocation. There are
several ways in which private speculation can bring about the wrong exchange rate.
5. An example of irrational speculation is a too risk-averse foreign exchange market. It
often attaches too high a probability to the possibility of a depreciation of a ‘weak’
currency or an appreciation of a ‘strong’ currency. One currency is regarded as too
risky and the other as safe. Forecasts are not only made on the basis of currently
available information but also on past performance, maybe leading to an unjustified
reluctance to move out of the safe currency to hold risky currency. The safe currency
becomes overvalued and the risky currency undervalued. Instability of a country’s
economic policies may well create uncertainty and therefore risk concerning estimates
about the correct value of its currency.
6. Irrational speculation - The ‘bandwagon’ effect: there is too much self-generating
speculation that is detached from the fundamentals: ‘speculation feeding upon
speculation’ rather than the fundamentals. If, for example, there is an unexpected
money supply, which sets off unjustified speculation, this could eventually lead to an
even greater rate of monetary growth. Assumption: foreign exchange speculators do
not use all the information and news available to them efficiently, and consequently
speculation produces the wrong exchange rate until eventually fundamentals reassert
themselves.
7. It is also possible that speculators are rational but that there is uncertainty and they do
not know the correct exchange rate model. See 3, 4 and 5 for this. They could use a
seriously defective model. This will generally lead to the wrong exchange rate.
Market participants may be impressed by a plausible but relatively unimportant
fundamental variable and make their expectations based upon movements in that
variable that come true. A danger is that economic agents may shift their attention
between many irrelevant pieces of information, causing excessive exchange rate
variability and even major exchange rate collapses.
8. The Peso problem – exchange rates are determined not only by what is held to be the
underlying fundamentals today, but by what is expected to happen to those
fundamentals in the future. Perceptions about the future can prove to be seriously
wrong and in this case the exchange rate moves immediately in anticipation of events
that will not happen. This can interfere with macroeconomic policy and
macroeconomic stability.
9. Rational bubble – an exchange rate bubble exists when holders of a currency realize
that it is overvalued, but are nevertheless willing to hold it, since they believe that the
appreciation will continue and that there is only limited risk of a serious depreciation
for the given holding period. Such speculation both prolongs an exchange
overvaluation and aggravates the macroeconomic costs associated with it.
The optimum currency area
An optimum currency area is a region for which it is optimal to have a common currency and
a common monetary policy. What is the optimum number of countries that should join the
euro and what criteria should be used to evaluate the suitability of a prospective member for
joining the euro? Some criteria that have been suggested:
1. Degree of factor mobility internationally – higher degree is more beneficial to form a
monetary union. High capital mobility will enable a country to finance a BoP deficit
more easily without the need of an exchange rate depreciation.
2. Degree of financial integration – ability of a country to gain access to external
finance. Higher degree of financial integration = more able to finance deficits = less
dependent upon exchange rate changes.
3. Degree of openness – more open = more tradables relative to non-tradables = more
vulnerable to inflation from a depreciating currency and unemployment from an
appreciating currency > less desirable exchange rate changes > more profitable to join
monetary union.
4. Degree of product diversification – less variability in exports earnings and import
expenditure > more stability BoP > less resorting to exchange rate changes > more
benefits from joining monetary union.
5. Degree of similarity of inflation rates – PPP suggests that there is no need for
exchange rate changes when inflation is similar.
10.3 The case for floating exchange rates
1. Floating exchange rates ensure balance of payments equilibrium – the exchange rate
automatically adjusts to ensure continuous equilibrium between the demand for and
supply of the currency. If there is a CA deficit, the exchange rate will depreciate
which will reduce imports and increase exports until the BoP is restored to a
sustainable level. Excess demand leads to an appreciation, whereas excess supply
leads to a depreciation (instead of a fall in the authorities’ reserves). Under fixed
exchange rates, even if by chance the authorities initially peg the exchange rate at the
point where supply equals demand, that rate will soon become inappropriate due to
changes in economic fundamentals. Exchange rate adjustments relieve the authorities
of having to adopt unpopular alternatives such as deflation or protectionism.
2. Floating exchange rates ensure monetary autonomy – floating exchange rates
restore monetary autonomy by enabling each country to determine its own inflation
rate. This contrasts with what happens under fixed exchange rates where the need to
have common inflation rates to maintain competitiveness constraints countries to
pursue similar monetary policies.
3. Floating exchange rates insulate economies – Floating exchange rates can insulate the
domestic economy from foreign price shocks. If there is an increase in foreign prices,
the domestic currency would appreciate, preventing the country from importing
foreign inflation. Under fixed rates, a foreign price increase would make the home
economy over-competitive, leading to a BoP surplus which necessitates purchases of
the foreign currency with newly created domestic currency to peg the exchange rate.
This increase in the domestic money supply leads to an accompanying rise in
domestic prices, thus ending the surplus.
4. Floating exchange rates promote economic stability – the exchange rate is a variable
which can easily rise or fall, whereas domestic prices tend to be very difficult to
reduce. If there is a loss of competitiveness, it is better to allow the exchange rate to
depreciate (domestic currency appreciate?) rather than maintain a fixed exchange rate
and require deflationary policies to restore it. The domestic price level is resistant to
downward pressure, so severe deflationary policies would be needed (high
unemployment, fall in wages etc.).
5. Private speculation is stabilizing – Private speculators are a stabilizing rather than
destabilizing force. Speculators will attempt to buy the currency at a low value and
sell at a high value and in doing so reduce the gap between low and high values. It is
in their own interest. Of course, sometimes they make mistakes, but as this involves
losses, there is every reason to suppose that private speculators will move the
exchange rate towards its equilibrium value.
10.4 The modern evaluation of fixed and flexible exchange rate regimes
The exchange rate regime that provides the most stability to the domestic economy is deemed
to be the preferred regime. Modern literature does not provide an unambiguous answer to the
question of which is the best exchange rate regime. The choice is crucially dependent upon
the multiplicity of factors. For example, the specification of the objective function, the type
of the shock impinging upon the economy, and the structural parameters of the economy.
10.11 Managed floating
Necessary assumption: the authorities can influence the nominal and/or real exchange rate in
the desired direction – without such an assumption no rationale for intervention can exist.
Furthermore, only if it can be demonstrated that intervention has a superior benefit to cost
impact than other policies, can exchange market intervention be justified. There are three
arguments for some degree of discretionary intervention:
1. Authorities might be able to produce a more appropriate exchange rate
The exchange rate produced by the market may be the wrong rate compared to underlying
economic fundamental: the wrong model may be used, there are wrong perceptions about the
future or the implications of news are difficult to interpret. There exists a case for
intervention if the news or information available to the market is efficiently used but the news
itself is either inadequate – increasing risk – or misleading, and the authorities are in
possession of superior relevant information. In this case intervention may be stabilizing and
profitable. Of course, the information might also be released into the market and so let the
market do the work (but: market might not believe them, undesirable information etc.).
Another argument for the authorities to intervene is that, while it may be the case that the
authorities do not know more than the market regarding what is the correct rate, they should
know better and sooner what they themselves are about to do. Since the foreign exchange
market is efficient, the expectations of a depreciation lead to a smaller discrete depreciation
of the current rate (reflecting the news of a future monetary expansion), with a gradual
depreciation thereafter until the actual increase in the money supply takes place. In this way
all anticipated disturbances are fully discounted and therefore unusual ex ante profit
opportunities eliminated.
If there is news that the growth rate of the money supply will be increased, this may affect
speculators’ expectations in at least three possible ways: (1) seen as a transitory development
of a countercyclical nature that will subsequently be reverse; (2) seen as a once and for all
change in the money stock but not affecting the rate of growth of the money stock; and (3)
seen as heralding a more permanent increase in the rate of growth of the money stock. Each
of the alternatives have different implications. The greater the actual growth the greater the
required depreciation. The market does not know the required depreciation – the authorities
however do (and could indicate this by an intervention policy).
1. Intervention needed to mitigate costs of exchange rate overshooting
The Dornbusch model showed that a move to monetary restraint can lead to a short-run real
exchange rate appreciation while an expansionary monetary policy can lead to a real
depreciation. Exchange rate misalignments = substantial and prolonged deviations from PPP.
Misaligned exchange rates distort the allocation of resources between tradables and nontradables. Undervaluation > rise domestic price level > downward pressure on wages >
inflationary pressures. Misalignment complicates investment due to uncertainty of the
duration of the misalignment, which will affect profitability calculations.
Misalignment almost certainly exerts a ratchet effect on protectionism. Undervaluation >
resources that are not viable enter into tradable sector > correction of exchange rate > come
under pressure > seek recourse to protection. Protectionism is a global and persistent
phenomenon since an undervaluation of one currency represents an overvaluation of another
currency, as long as exchange rates are misaligned. Correction of misalignment involves
adjustment costs.
Foreign exchange intervention is meant to reduce the costs and extent of exchange rate
overshooting. In this case the rate produced by the market is the correct rate but because of
‘sticky’ good prices there are short-run real exchange rate changes. Some suggests that
authorities should therefore tackle inefficiencies in the goods and labor markets, instead of
using the foreign exchange market. This would lead to quick inflation rates adjustments in
response to monetary policy. Furthermore, anti-trust legislation, reductions in trade union
power and the reduction of social security benefits would be proposed to make prices more
flexible, reducing the problem of overshooting However, this would likely lead to resistance
> foreign exchange intervention is a superior policy tool.
1. Intervention to smooth the economic adjustment process
Rationale: achieve a preferable exchange rate in the short run to permit a smoothing of the
necessary adjustments that the economy must for various reasons undergo. It is a painful
process for those who have to adjust and is more acceptable at a controlled pace than at a
market-determined pace.
Suppose: BoP surplus > traded goods larger than non-traded > tendency for appreciation of
real exchange rate > possibility of large transitional unemployment > authorities moderate
appreciation > traded goods move slowly into the non-traded sector, instead of rapidly as to
avoid large costs.
Another scenario is when the tradables sector is divided into booming and lagging sectors.
The booming sector will cause tendencies for the real exchange rate to appreciate > speed up
the demise of the lagging sector = not favorable.
Exchange market intervention can be seen as protection. Exchange rate protection involves
influencing the real exchange rate and with it the accumulation of reserves. This is temporary,
whereas tariffs and subsidies are more permanent > retaliation. Tariffs distort production
patterns > lagging sectors are protected. But exchange rate protection protects all tradables =
more widespread > more likely to invite retaliation.
Consider the vicious cycle: CA deficit > depreciation to try to eliminate this > increased
domestic price of currency > wages adjust immediately > accommodating monetary policy
adopted to avoid increase in unemployment > country is back where it started = vicious
cycle. Intervention in the FX market may reverse this or slow it down. However, the real
issue behind this argument for intervention concerns the effectiveness of different policy
instruments in bringing about the ultimate reduction in real wages that is essential for
adjustment (in the absence of productivity improvements), while minimizing the harmful
consequences for other macro-objectives (employment, price stability). There may be a case
in the vicious-circle argument for government intervention to slow down the rate of
depreciation so that real wages are reduced only gradually at a more acceptable pace.
Ideally, the exchange rate should be allowed to adjust towards its equilibrium rate at an
optimum page. It Is the acceptance of the principle of exchange rate adjustment that ensures
that the required changes in the economy do take place.
10.12 Conclusions
There is no clear-cut reason to prefer fixed or floating exchange rates. Many advantages can
under some circumstances be viewed as disadvantages. For example, floating exchange rates
restore monetary autonomy, but whether this is a good or bad thing will depend upon whether
the authorities use the autonomy wisely. Only under very specific conditions can we say that
one regime is better than the other. It depends especially upon the specification of the
objective function. Even the same economic structures and similar shocks does not mean that
these countries have to adopt the same exchange rate regime. The implication of wages
indexation, the possibility of permanent shocks and the relationships between various shocks
may complicate the choice even more. The lack of decisive arguments in favor of either fixed
or floating exchange rates has frequently been taken as a rationale for some degree of
exchange rate management between the two regimes. Over-speculation or overshooting
which leads to a wrong rate does not by itself justify intervention. It is necessary to
demonstrate that a more appropriate rate can be chosen and that intervention does have an
influence. Furthermore, it should be demonstrated that influencing the exchange rate is the
best means of tackling the economic problem. There is no unique set of rules, so an
appropriate intervention policy may involve reducing or exacerbating exchange rate
movements, intervention may need to be temporary or prolonged, and the amount of
intervention required will vary with the circumstances.
Chapter 11: The International Monetary System
11.1 – 11.3 Bretton woods
After the Second World War, Europe was in ruins. London lost its position as an international
financial center, the European countries did not have foreign exchange and the capital stock
had shrunken tremendously. In 1947, 44 countries decided on establishing the Bretton Woods
system too. This system also had the purpose of helping the economies in the reconstruction,
and so there would again be hyperinflation of a stock market. Core of this system was that
countries had to change dollars, which was linked to a certain amount of gold. Through this
system of fixed exchange rates, it was hoped that the economies might recover and that world
trade would increase. The currency would not have any latitude: one bandwidth of ± 1
percent. Countries might devalue their currency, to one maximum of 10 percent without the
IMF, see below.
Another part of the Bretton Woods system was the establishment of an International
Monetary Fund, whose task was to prevent re- and devaluations. The IMF can do this by
providing loans to countries that have problems with the balance of payments. Money
supplies are supplied by the members of the IMF. Everyone pays a certain quota, and can
therefore make use of it. If the IMF has to make large loans, they provide requirements, for
example about the policy to be implemented. The loans from the IMF are called the Special
Drawing Rights.
A third component was the World Bank, consisting of the International Bank for
Reconstruction and Development (IBRD, that's the name of the World Bank), the
International Development Association (IDA) and the International Finance Corporation
(IFC).
11.4 A brief history of the Bretton Woods system
After the Second World War, Europe did not have enough foreign exchange to buy capital
goods abroad for reconstruction. The United States decided to jump in, and from 1948
Europe received so-called Marshall aid in US dollars. Condition, however, was that more
cooperation would be started in Europe. The creation of the OECD (Organization for
Economic Cooperation and Development) was the first
step. The first problems arose some ten years later. The United States had one deficit on the
basic balance. It turned out that there was too little gold to cover the outstanding deposits. It
was decided to set up a dual market for gold, a market for Central banks and a private market.
On the official market (Central Banks) the value of 100 grams equaled the Bretton-Woods
value, while on the private market it was clear that the dollar was highly overvalued. This
went well for a while, until the United States became embroiled in the Vietnam War. The
trade balance now showed also a shortage.
In 1971 the president of that time, Nixon, decided to protect the dollar by imposing a high
import tariff and to stop the exchangeability of dollars for gold. In the end, the dollar
devalued anyway. The bandwidth for the other currencies was increased to 2.25 percent and
the import tariff was abolished again. There was a lot of speculation around the dollar. In
1973, some European countries decided that they would allow their currencies to float in
comparison to the dollar, and that they were going to maintain a bandwidth among
themselves.
This treaty is called the snake in the tunnel, where the snake is the narrow bandwidth with
respect to each other (1.125 percent) and the tunnel the wider with respect to the US dollar
(2.25 percent). A few months later they left the tunnel and the currency could float against the
dollar. This was the end of what was called Bretton Woods.
11.5 Why did the Bretton Woods system break down?
The collapse of Bretton Woods has several causes. First there was the overvalued dollar.
There is a law, Gresham's law, that says: bad money will drive out good money. In this case
the dollar was the bad money type and gold the good one. Nixon's prohibition to exchange
dollars for gold, proves in this case that bad money drives good money away.
Secondly, there are the adjustment problems. The United States had shortages, and they
should have devalued their currency. This did not happen. Other countries, where there was a
surplus, would have been able to respond, but this did not happen because of fear of
unemployment and inflation. Ultimately, such an unbalanced situation leads to a crisis.
Thirdly, there was the currency wage, or seigniorage. The shortages of the United States
arose because more was consumed than produced. This consumption was financed with 'new
money'.
Finally, there was the liquidity problem. Triffin already saw this problem. The world trade
would grow strongly after the war. This would require a lot of gold, which there was not. So
the dollar would not keep the value that he had been awarded, namely US $ 35 per ounce.
Central banks would lose their confidence in convertibility and exchange their dollars for
gold (gold that was not there). The deficits of the United States would undermine BrettonWoods. Possible attempts by the U.S. to reduce deficits would reduce the growth of world
trade. This problem is also called the Triffin dilemma.
11.6 -11.16 Chronology
19739: The first oil crisis took place. Many oil-importing countries were confronted with
deficits on the current account. Unemployment and higher inflation arose. The oil-exporting
countries made huge profits and these so-called petro dollars were invested abroad. After this
crisis the system of fixed exchange rates was renounced.
1976: At a conference in Jamaica the foundation was laid for a system of floating to race. The
role of the IMF was further specified and the role of the Special Drawing Rights became
greater. Freedom remained paramount, but the IMF was surveying.
1979:
 The Snake arrangement was accepted.
 The second oil crisis took place, recovery went more smoothly than in 1973.
1980-85: The dazzling dollar applies. The cause is the large number of different forms of
monetary policy. The United States had a growing trade deficit and one government deficit
and there was some concern. The United States also carried protectionist measures.
1985: Plaza-accord: the G-5 (France, W-Germany, Japan, V.K. and V.S.) decided to
depreciate the dollar. Floating courses did not work perfectly.
1987:
 February: Louvre agreement: the G-7 decided that the dollar was far enough
depreciated. Probably new bandwidths have been agreed there.
 October: collapse of stock market. The dollar was under pressure again. The central
banks lowered their interest rates in order not to let the investments shrink too much.
1990: The nineties again caused unrest. Because of the fall of the Berlin Wall, East and West
Germany were unified. This event had an inflation risk . The interest was raised several
times. Due to this increase, the U.S. and the U.K. were in a recession. Many currencies in
Europe devalued. The bandwidth was increased from ± 2.25 percent to ± 15 percent.
1994-1995: The Mexican 'tequila' crisis
1997: Instability of the Dollar
1997-1998: Asian crisis
1998: Russian crisis
1999: Brazilian crisis.
Long-term capital management crisis.
2001: Turkish crisis.
2001: Each country is free to determine monetary policy. Link to the US dollar is not
allowed.
2002: Argentine crisis.
2007: Credit crisis.
2010-present: Eurozone crisis.
11.17 – 11.21 Developments
More international stability is still very desirable. Several proposals have been made to create
a more stable zone. Some of these will now be discussed:
1. McKinnon Global Monetary Target Proposal:
Two countries should link their currency. A surplus of money supply would then be in the
past tense. The total money supply in the world market remains constant. According to
McKinnon, currency substitution causes a lot of volatility in the exchange rate. It has been
shown, however, that this is not too bad. It is rather likely that the substitution between
domestic and foreign bonds causes fluctuations.
1. Williamson target zone proposal:
A zone around an equilibrium value should be created for each currency unit, within which
the currency can fluctuate. Williamson called this equilibrium value fundamental equilibrium
effective exchange rate, or the FEEER. This FEEER fits to economic developments in the
country. The boundaries of the zone must be soft, so that speculators do not know when an
adjustment will be made as the exchange rate limit is approaching. This would reduce
destabilizing speculation. There is a lot of criticism being voiced against this proposal.
1. Tobin foreign exchange tax proposal:
According to Tobin, short-term capital flows have a destabilizing effect on the economy. As a
result of these capital flows, governments no longer have room to conduct independent
policies. To limit these flows, he proposes a tax. As a result, the efficiency of the markets will
become smaller. The tax will only have to slow down the short-term flows. Possibly also one
tax on goods may be levied. The effect of the tax will be a smaller exchange rate volatility,
and more autonomy for governments. Critics say that short term capital flows may also have
a stabilizing effect. Moreover, it is in practice not feasible. There will always be ways to deal
with this tax evasion. Furthermore, the market is more limited and the volatility may actually
increase.
11.22 Conclusion
After the Second World War many developments took place on the international financial
markets. Countries have become more dependent on each other, because of, among other
things, the greatly increased world trade. Unfortunately, there is still no stable international
exchange rate system. Floating exchange rates were also not ideal.
Chapter 14: International Macroeconomic Policy Coordination
14.1 Introduction
By definition: small open economy has no significant impact upon its trading partners. In the
real world however, the actions taken by one country will often have significant effects upon
its trading partners. So policy measures adopted by one country may provoke a reaction from
its trading partners. Interdependency > coordinate their macroeconomic policies to prevent
conflict and the pursuit of unilateral policies.
14.2 What is meant by international policy coordination?
International policy coordination is primarily about some form of a cooperative relationship
between the policy-makers/authorities of two or more nations. It does not per se directly
involve the private sector. An arrangement made might sometimes even be undermined by a
suspicious private sector.
Level 3: the exchange of information – minimal type of coordination. Information could
include authorities’ views about the appropriate value of the exchange rate; the present/future
course of macroeconomic policies; intention with regard to future exchange market
intervention; principal objectives of policies etc. Advantage: understand how conflict can be
prevented and where uncertainty lies.
Level 2: mutually consistent policies – authorities pursue mutually compatible target values
and adjust the selection of policy instruments. Each country takes into account the aims and
policies of other countries when formulating its own policy stance.
Level 1: joint action – to achieve desired targets, as for example a certain value of the real
exchange rate, the two countries/authorities could work together to manipulate the exchange
rate in the desired direction. Literature focuses mainly on two types of joint action: 1 is when
fiscal and monetary policies are adjusted to maximize joint welfare and 2 is when the
exchange rate is jointly targeted.
14.3 Why does the need for international policy coordination arise?
It wouldn’t be necessary if exchange rate changes truly insulated one country from another
(=independence). However, economies are affected by the policy mix pursued in other
economies. In particular, the phenomenon of exchange rate overshooting means that the
monetary policy pursued in one country will lead to spillover effects on its trading partners. A
depreciation in the home country means an appreciation in the foreign country. Economic
policy coordination is necessary if economic policies themselves have effects upon the real
economy (employment and output levels).
Some argue that policy coordinating may be due to market imperfections (irrationality, not
competitive, prices not fully flexible, adjustment costs negligible, no instantaneous reactions
to shocks).
Frenkel: countries are connected by:
1. Trade flows: the exports of one country are the imports of another; changes in volume
will affect employment.
2. International capital movements; permit the transmission of economic disturbances
from one economy to another by freeing an economy from the need to keep its current
account in balance. Besides that, capital movements also have the effect of tying up
international interest rate differentials and expected exchange rate changes together
through the UIP condition. So policies that influence domestic interest rate > have
effect on trading partners through induced changes in real exchange rate.
Interdependence: a situation whereby the structure of two or more economies are such that
economic events in one significantly influence economic events in the others. So if economic
policies adopted in one country affect its real economy then they will also have spillover
effects on other countries. Interdependence means that a country cannot achieve its objectives
without these being mutually consistent with those pursued by other countries.
The need for policy coordination is especially acute when the trade and capital linkages are
high.
14.4 The benefits from international policy coordination
Benefits depend upon the type and degree of coordination undertaken. Coordination = means
of preserving/improving benefits associated with increased interdependence (gains from trade
and access to capital markets). The Hamada diagram illustrates the potential gains from
coordination of macroeconomic policies (see figure 14.1 on page 357 in Pilbeam). EU is
shown on the x-axis and America on the y-axis. Further long the EU line, the macroeconomic
policy stance may be more expansionary (and likewise as we move up the US line). There
must be a point on the diagram for Europe E* that gives a combination of its own policy
stance and that of America which it prefers to all other possible policy combinations. Similar
for America A*. We can draw sets of elliptically shaped indifference curves that denote
combinations of EU and US policies that yield the same level of utility. The closer the utility
curve to E*, the higher the utility for EU (same for America; closer to A*). Independence
would mean a vertical straight line (US) or horizontal straight line (EU). Each could then
achieve its optimal level of welfare merely by adjusting its own policy instruments,
regardless of the policy of the other country.
A reaction schedule of the EU can be found by taking a given policy stance of the US and
finding the utility curve UE which is tangential to it: this is the utility closest to E*. One can
find various other optimal policy stances of Europe given a different policy stance of the US,
and by joining the points together one obtains the policy reaction function of Europe RE. The
locus of points passing between E* and A* where the utility curves are tangential to one
another along the contract curve indicate that one country can be better off only by making
the other country worse off. In this region we have reached a pareto-efficient point.
(See figure 14.2 on page 358 in Pilbeam) To establish potential gains from international
macroeconomic policy coordination it is necessary to compare the possible situation under
coordination vis-à-vis a scenario of non-coordination. Figure 14.2 compares possible
coordination scenarios with two popular non-coordination scenarios known as Nash and
Stackleberg equilibriums. In a Nash non-cooperative scenario = each economy takes the
policy stance of the partner economy as beyond its influence and adopts its optimal
isolationist policy. A Nash equilibrium is reached when there is no incentive for either
economy to change its policy stance, taking the other’s policy as given. This is point N where
the two reaction curves intersect. With the Stackleberg scenario, one of the two countries is
assumed to be more intelligent than in the Nash scenario and realizes that its policy stance
influences the choice of another country, while the other (follower) ignores the influence of
its policy stance on the leader. If America is the leader this leads to point S with UAS that is
tangential to Europe’s reaction schedule. This is the closest indifference curve to point A*
that America can reach knowing the whole range of possible reactions of Europe. However N
and S are not pareto efficient as there are combinations that would make them both better off.
If the economies agree to coordinate to get onto the contract curve A*E* both countries
would be on higher utility curves. Coordination can improve welfare.
14.5 A game theory demonstration of the gains from coordination
In this payoff matrix we assume that the pay-off to each economy is measured by a ‘misery
index’, which is simply the sum of an economy’s inflation and unemployment rates. We
assume that inflation is just as bad as unemployment. The aim will be to minimize an
economy’s misery index. The first number is the outcome for Europe.
Suppose that each economy seeks to minimize its misery index but chooses its policy
package in isolation without any coordination. Europe does not know what policy will be
pursued by America, so it will choose policy 1 (result of 12 or 7, which is in both cases lower
than the outcomes for policy 2 – no matter what America does). America pursues policy 3
since this will make them better off in both cases (no matter what Europe chooses). The result
of making policy decision in isolation is (12,12). So non-cooperation is worse than if Europe
and the US made an agreement to pursue policy 2 and 4. A problem with such an agreement
is that there may be an incentive of one or more of the parties to renege on the agreement. As
such, there may need to be stiff penalties against parties that renege and a monitoring system
designed to spot any reneging country.
14.6 Other potential benefits from coordination
The Hamada diagram assumes that each country knows the range of potential policies that the
other country could pursue and can also calculate the consequences of various policy
combinations on its own welfare. In the real world we can expect gains such as:
1. Reduction of uncertainty – which relates to the implementation of the policy. In the
real world, countries rarely know the course of action that will be taken by other
economies and their probable reactions to changes in their own policy stance.
Coordination has the potential to reduce the possibility of serious conflict. Superior
policies (with less serious shortcomings/miscalculations about the reactions of foreign
authorities) can be pursued when more information is available. Error = costly.
2. Avoidance of excessive deflation – the authorities might be tempted to control
inflation in isolation by announcing today that money supply growth will be lower in
the future. If such an announcement is believed, the authorities of that country will
benefit from an immediate real appreciation of their currency reducing present
inflation (other countries experience depreciation). In the absence of coordination,
countries might be tempted to engage in competitive announcements. With
coordination > less danger of deflation.
14.7 The potential for coordination to make countries worse off
Since in the worst case countries could cooperatively agree to pursue similar policies as in a
non- coordination scenario, then the policies they choose under coordination must be superior
or they would have pursued the non-cooperative policies. However, there are 3 instances in
which coordination between two or more countries may make the participating countries
worse off rather than better off.
1. The reaction of private agents – Rogoff: the behavior of private agents cannot be
considered by the authorities as indifferent to any arrangements that they come to
with trading partners. Consider this case: national authorities seek to raise the level of
employment in their economies in a model in which there is exchange rate
overshooting. Acting in isolation, countries will not inflate because they know this
will lead to a real depreciation, which will raise import costs and adjust domestic
wages and prices upward. If central banks however inflate and raise employment
levels together, they can overcome the fear of a depreciation of their real exchange
rate. However, private agents will take this additional inflation risk into account when
setting their wage contracts and raise their wage demands accordingly. So under
coordination, inflation might be higher than anticipated. Coordinating governments
can make institutional changes to improve their credibility (such as making their
central banks independent with a commitment to price stability).
2. The reaction of third countries – A negative reaction by a third country may have
adverse effects. If the EU and US decide to deflate their economies in their joint
interest, then adverse effects for Japanese exports might lead Japan to deflate its
economy which then exacerbates the recession in US and EU above what they had
anticipated, making them worse off (than if they hadn’t agreed to joint deflation).
3. Cooperation based on the wrong model – there is uncertainty over the true economic
model (linkages, structural parameters, relationship between instruments and targets
not known). If models turn out to be wrong, then the agreed cooperative strategies
may be seriously defective and make one/both countries worse-off.
14.8 Estimates of the benefits and losses from international policy coordination
It is practically impossible to measure the benefits/losses from international policy
coordination in the real world, because of the perennial problem of estimating what would
have happened in the absence of coordination. However, Frankel and Rockett have tried.
They tested 10 models and assumed that every government believes that one of the ten
models is the correct economic model. Each country agrees to coordinate with the other
country to maximize their perceived joint welfare as compared to the perceived Nash noncooperative outcome. In total there are 100 coordination scenarios to examine (10 x 10) the
welfare consequences for. And for every 10 models, 1 is true and the other 9 false and they do
this for every model so there are 1000 possibilities. Change of being worse-off from
coordination was approx. 32% (because of using the wrong model). However, they argue that
if uncertainty is taken into account, the benefits from coordination might be higher. In
practice, governments will wish to avoid circumstances in which they benefit and the other
country is made worse off > scared for renege. Potential gains from coordination = not very
high. It is argued that in the long run there are not even benefits as in each country the
equilibrium level of output is determined by a vertical Phillips curve and floating exchange
rate permits the desired level of inflation to be achieved without the need for international
policy coordination. Others find that a combination of fiscal and monetary coordination can
in fact lead to higher gains (especially when there are permanent common shocks).
14.9 Problems and obstacles to international policy coordination
The Bretton Woods system, the EMU, the IMF and the OECD are all examples of differing
types of international macroeconomic cooperation.
Some obstacles that inhibit greater international macroeconomic policy coordination:
1. Negotiation and reduced flexibility costs – an obstacle to actually achieving a
successful coordination package is the negotiation process, i.e. reaching agreement on
a successful policy (difficulty increases with the number of targets, instruments and
countries). It is also difficult for governments to precommit themselves to fiscal
policy.
2. Disagreement over appropriate macroeconomic policies – the debate in
macroeconomics over the role, impact and effectiveness of fiscal and monetary
policies and major international policy issues (fixed/floating exchange rates) is far
from settled. This disagreement is not restricted to the quantitative effects but also to
the qualitative effects, and to the appropriate instruments.
3. Not all countries gain from coordination – if the pay-off matrix is known and meansend relationships are fairly clear, it may be possible for policy-makers to improve
their joint welfare by cooperation. However, some countries may be worse-off when
designing the agreement. In such circumstances, to make it worthwhile for loser
countries to engage in policy cooperation, it is necessary that some form of
compensation is paid (especially when they have to make the biggest policy
adjustments). In practice, this means that cooperative agreements may be restricted to
instances where all countries are made better- off which would accordingly reduce the
potential gains from coordination.
4. Reneging and the problem of time consistency – when using dynamic game theory,
this highlights the problem of time consistency. Time inconsistent = an incentive
exists to depart from the policy at any time now or in the future. This can pose a threat
to coordination – a country which reneges on a time inconsistent cooperative
agreement may retain an advantage in the long run. Furthermore, making an
agreement time consistent may lead to inferior outcomes. Besides, by breaking a
cooperative agreement the authorities may face penalties from other countries and be
excluded from future participation in cooperative agreements. In practice, the costs
will exceed the benefits.
14.10 Conclusions
International policy coordination is so complex, that we should not expect coordination to
yield global optimal solutions. The recent Eurozone crisis has shown that fiscal policy
coordination is necessary for the successful operation of the zone. Cooperation has proved
easier in the trade arena with such arrangements as the General Agreement on Trade and
Tariffs and the EU. Trade literature says: increased trade is always beneficial for all countries.
Macroeconomic literature: not so sure – is monetary and fiscal policy even effective in
influencing economic activity?
Uncertainty can be both an obstacle and an incentive to international policy coordination. The
move from fixed to floating exchange rates has coincided with a decline in the relative
economic influence of the US. During Bretton Woods: the US was the lead and EU and Japan
the followers in the Stackleberg scenario. Now no longer this scenario – at this point more
danger of a Nash-type scenario.
Global coordination: countries from different regions of the world that have a significant
impact on the global economy. Sub-global coordination: coordination between countries
which are not necessarily important at the global level but have a high degree of structural
interdependence with one another.
Chapter 15: The Latin American Debt Crisis
15.1 Introduction
In 1982, The Mexican government announced that it could not meet its forthcoming debt
repayments on its $80 billion of outstanding debt to international banks. Restrictions on
financial markets is a characteristic of LDCs. Throughout 1980s and 1990s, the problems
faced by developing countries in servicing their debts have been one of the major
international policy issues. Granting debt relief has recently also becomes a major policy
issue.
The severely indebted middle-income countries (SIMICs):
 Argentina
 Brazil
 Mexico
 Venezuela
The classification of a SIMIC is that the country must be a middle-income country (an annual
income of between $725 and $9,075 per capita) and have one of two key ratios above certain
critical levels. These ratios are the present value of debt to gross national income (GNI) 80%
and the present value of debt to exports of goods and services (220%).
 MIMICs (moderately indebted middle-income countries)
 SILICs (severely indebted low-income countries)
 MILICs (moderately indebted low-income countries)
 LIMICs (less-indebted middle-income countries)
15 SIMICs in 1994 were concentrated in Latin America, a combined external debt of $587.4
billion, the majority was owed to private sources made up primarily of commercial banks. 35
SILICs in 1994 were in sub-Saharan Africa, their combined external debt of $223.6 billion,
mostly owed to governments and official agencies and the remainder to private sources.
The Latin American Debt Crisis raised many questions:
1. How did the crisis come about?
2. Why did international banks lend so much money to these countries?
3. Why did the indebted countries not go into outright default?
4. How was the debt crisis managed?
5. How successful has the management of the crisis been?
Focus on the debt problems of Mexico, Argentina, Brazil and Venezuela.
The concentration of commercial bank loans in these four economies led to fears that if any
of them defaulted, this would undermine the US banks that lent to them, and threaten an
international financial crisis. The knock-on effects would push the world into a major
economic recession.
15.2 The low and middle-income developing countries
Developing countries are traditionally distinguished from the developed economies by their
lower per capita GNP.
Developing countries can be placed into two categories:
1. Low-income developing countries: countries with incomes of less than $735 per
capita at 2002 prices e.g. sub-Saharan Africa.
2. Middle-income developing countries: countries with incomes > $725 per capita and <
$9,005 per capita at 2002 prices e.g. Argentina, Brazil, Mexico and Venezuela.
15.3 Characteristics of typical middle-income developing countries
Main differences between developed and middle-income less-developed economies:
1. Financial markets
Government controls banks
Limited investment opportunities for savers and are subjected to high degree of government
control.
Forces low interest rate to stimulate investment
Companies are heavily reliant on banks for funding, these banks are usually state-owned or
subject to heavy government control aimed at maintaining low real interest rates.
The problem with low real interest rate policies is that they tend to discourage saving, which
is already low because of low income levels. Low savings + low interest rates lead to an
excess demand for funds (which requires credit rationing). Low interest rates stimulate
expenditure on imports contributing to BoP
problems.
 Excess demand of funds
 Borrow from abroad: CA < 0
 External debt increases
If markets are liberalized, then (1) weak institutions (2) lending to risky projects:
1. Forex market characteristic: exchange rate pegging and exchange controls.
 Government pegs rate (e.g. to dollar) to reduce inflation.
 If the US dollar appreciates, the developing countries’ exports worsen.
 Restrictions on capital outflows (the purchase and sale of foreign currencies)
 By restricting the ability of their residents to invest their savings abroad, the controls
enable the government to borrow funds from its residents at a lower rate of interest.
 Controls reduces capital outflow: restricting the sales of the home currency and
reducing the strain on foreign currency reserves which would otherwise be required to
defend a pegged exchange rates.
 Allocation of forex through government decree rather than market.
 Residents require government permission to purchase foreign currencies.
 E.g. if the foreign currency is required to pay for imports of capital equipment, the
authorities will usually offer a more favorable rate of exchange than for the import of
luxury consumption goods.
 Characteristics regarding financial (including forex) markets in one word: restrictions.
1. Low degree of diversification
Output of less-developed economies is far less diversified. Agricultural output represents a
high proportion of GDP and exports are mainly raw materials and agricultural goods. This
means their economic performance can be subject to a wide degree of fluctuation due to bad
harvests or change in value of their principal exports. This price variability means that
incomes and trade performances of
developing countries can be subject to large year-to-year fluctuations. Recessions in
industrialized countries are especially harmful to developing countries as they experience
both a fall in the price of primary products, decline in export volumes and large reductions in
export revenues.
1. Inflationary environment
Developing countries tend to have high inflation rates. Government budget deficits are
financed by the government resorting to money creation because
1. Financial markets are too rudimentary to raise the required borrowing from domestic
sources and because
2. Governments find taxing citizens to be politically unpopular. The resulting inflation
reduces the real value of money held by domestic residents and reduces the real value
of outstanding government debt.
15.4 The economics of developing country borrowing
Why were middle-income developing countries eager to borrow and the commercial banks so
willing to supply the funds? Developing countries have low incomes and poorly developed
capital markets so there is insufficient savings to provide the finance for domestic investment.
They have low capital stock so it means that there are plenty of opportunities for profitable
investment and low K/L means that MPK is high. By borrowing funds from abroad, they can
raise domestic investment above domestic savings, which in turn leads to a higher rate of
economic growth than in the absence of such borrowing. However, I > S – the country is
running current account deficit but it also means that there is capital inflow. Later on, the
developing country will have to repay the principal and interest on the loans. As for the
developed economies, high incomes and sophisticated financial markets lead to relatively
high savings ratios, but their low capital to labor ratio means that MPK is low, this restricts
the amount of profitable investment opportunities. This means that there is an excess of
savings looking for appropriate investment opportunities, which exist in abundance in
developing countries who in turn lack the required Funds.
Hence, there is the potential for profitable exchange between the developed and developing
countries – the developing countries can use the excess savings and developed countries can
earn higher returns from investing in them.
15.5 Different types of capital inflows into developing countries
Means for developing countries to attract capital inflows:
1. Bond finance
Governments can issue bonds to foreign investors with a guaranteed rate of interest and
whether or not it is denominated in domestic/foreign currency. Bonds issued in domestic
currency have ‘inflation risk’ because higher than expected inflation could undermine the real
redemption value of the bond.
Bonds issued in foreign currency have ‘default risk’ because a developing country will not be
able to redeem the bond.
1. Bank loans
Borrowing money from commercial banks of developed countries. This was the major source
of finance for Latin American countries. The ‘syndicated loans’ (loans made by syndicates of
international banks) were made in US dollars at floating rates of interest, so repayments could
be adjusted upwards or downwards in line with changes in international interest rates. The
key rate of interest is the LIBOR, the rate of interest at which banks in London lend dollars to
one another.
1. Foreign direct investment (FDI)
E.g. a foreign multinational acquiring equity in a domestically owned business. A
multinational expands an existing subsidiary. Foreign investors set a new enterprise in
developing countries. This is popular for multinationals to invest in developing countries,
because it gives them ownership and control over the business and this capital inflow
represents long-term investments and vote of confidence in developing countries.
1. Official finance
Developing countries can raise money for developmental purposes directly from foreign
governments and international institutions. Loans from foreign governments are made at
below market rates of interest as part of foreign-aid programs and so are loans from the
World Bank.
 Debt finance – country has to repay the principal and interest on its outstanding debt
e.g. bond, bank, and official finance.
 Equity finance – foreign investors own shares or have direct control of the companies
so the repayment is in the form of profits and dividends.
15.6 Measures of indebtedness
1. External debt as a percentage of exports of goods and services and external debt as a
ratio of its export earnings since export earnings are the means by which a country
earns foreign currency to pay of its debt. However, there are problems because there
is a high degree of fluctuations for exports.
2. Reserves as a percentage of total external debt. Shows how reserves can be used to
pay off external debt.
3. External debt as a percentage of gross national income. Says nothing about the annual
burden imposed on the country, the amount of repayments falling due.
4. Total debt service as a percentage of exports of goods and services. Measures public
and publicly guaranteed principal and interest repayments that the country has to
make as a percentage of its exports of goods and services. This gives an indication of
the annual burden faced by a debtor in relation to its export earnings.
5. Total debt service as a percentage of gross national income (GNI).
The measures do not necessarily provide an accurate picture of creditworthiness. They
neglect the differing degrees of vulnerability to external shocks, differing capacities to
increase export earnings etc.
An understanding of country-risk assessment is an essential background to the study of the
debt crisis because part of the blame for the crisis is attributable to the inadequacies of the
measures used by the banks when extending loans to the debtor nations.
Terms used in international debt crisis:
 Public and publicly guaranteed debt
Public debts are loans to developing country governments or to state-owned
enterprises. Foreign loans are made to the private sector of developing countries, but
because such lending is regarded as highly risky, it is usually necessary for the
developing country government to guarantee to fulfill the loan contract in the case of
nonpayment by the private borrower; this type of obligation is known as publicly
guaranteed debt. Exchange controls in many developing countries means that their
governments usually get involved in loan agreements between foreign and domestic
residents.
 Total external debt
Sum of private non-guaranteed debt and public and publicly guaranteed debt.
 Debt service
Sum of principal and interest rate repayments.
 Default
Country fails to make repayments in principal and/or interest.
 Moratorium
Developing country announces its refusal to make repayments of principal and/or
interest in the loan contract until it can come to an agreement over future repayments
with its creditors.
 Debt rescheduling
Occurs when all the repayments of principal and/or interest due are postponed to some date in
the future.
 Debt provisioning
Term used when banks decide to set aside funds into their reserves to cushion against costs of
a debtor nation defaulting on its obligations.
 Debt forgiveness
Creditor writes of part or all of the principal and interest payable on an outstanding loan.
15.7 Background and origins of the debt crisis; and 15.8 The emergence of the debt
crisis
International debt crisis of 1980s: LDCs and developed countries were severely affected. A
great deal of direct investment in developing countries took place in 1960s and 1960s in order
to exploit their raw material resources which were the necessary base for reconstruction in
developed countries. This is despite the fact that many Latin American countries like Bolivia
defaulted in 1931.
Two types of causes of the debt crisis
Internal causes: factors controllable by domestic government. The characteristics mentioned
earlier are mainly government failures:
 Low real interest rates, guarantees for banks, weak credit institutions: excessive
investment and moral hazard.
 Money creation to finance government expenditure.
 Interventions in trade, exchange controls.
 Acceptance of floating interest rates on debt (but this also depends on suppliers of
loads so it is also an external cause).
External causes: factors generated by world developments.
1. 1st oil shock
From 1973-74, oil price quadrupled
Effect on LDCs
 Oil importing countries experienced increase in value of imports MLDC ↑
 Worldwide recession, lower demand, XLDC ↓, CA deficits increase from $8.7 billion
in 1973 to $42.9 billion in 1974, terms of trade deteriorated, need for funds
Effect on OPEC members
 CA ↑ from $6.2 billion in 1973 to $66.7 billion in 1974, excess supply of funds
Flow of capital
 Recycle petro dollar from OPEC to LDCs (through Eurobanks) (LDC debt increase)
 OPEC members preferred to deposit their money within developed countries’
financial centers rather than lend directly to oil-importing developing countries
because they offered a security and range of investment opportunities for their funds
that the developing countries could not compete with
 The rise in inflation from the oil shock means that real interest rates in industrialized
countries were low or even negative
 Developing governments wanted to avoid having to adopt deflationary measures to
control their current account deficits so they sought to borrow funds from finance
deficits
 The view that Latin America was set for high rates of economic growth, led to a
‘recycling’ of the petrodollars in the form of massive lending to the developing
countries
 Eurobanks preferred floating interest rate (as deposits had floating rate)
 Because the rates they paid on their deposits were variable, they were keen
to protect themselves should the rates of interest they had to pay on deposits rise
 This let developing countries exposed to the risk of a sudden rise in world interest
rates
Not yet problematic: economic growth in LDCs, debt services payable
1. 2nd oil shock
Second oil shock (1979)
Again, recycling of petrodollars (LDC debt increases) at floating rates.
Industrialized countries ‘responded differently from those to 1st shock: they want to reduce
inflationary consequences so they use monetary contraction (because 1st shock had
demonstrated that, after allowing inflation to increase, it is difficult to bring it back down).
Developing countries wanted to borrow further funds and so their outstanding debt doubled.
Two effects:
1. Interest rates increase due to a rapid rise in US budget deficit, bankers were less
willing to lend to developing countries, floating rates on LDC debt increase meaning
recession induced developed economies to take a protectionist stance to lower imports
and so they squeezed developing countries’ export.
2. Recession, reducing developing countries export volumes XLDC ↓
The result of all these factors was that in 1982 most developing countries, particularly in
Latin America, found themselves with record levels of indebtedness and debt-service
repayments, while their ability to raise revenues to finance the repayments had greatly
diminished. Much of the borrowing they had undertaken had not been profitably used for
investment purposes but was merely wasted on inefficient
state enterprises and maintaining artificially high consumption levels.
1. US policy
US policy was quite extreme:
Volcker’s monetary policy: very stringent
 Reagan’s fiscal policy: very expansionary
 rUS>r ROW
 This contributed to dollar appreciation
 In home currency: LDC debt services increase (interest + principal repayments)
Note: debt was denominated in $:
 For countries with floating exch. rates against $, the $ appreciation was painful
 For countries pegged to $ it was also painful, given regular devaluation against $.
15.9 The Mexican Moratorium
Mid 1970s –
 Mexico had been a major oil exporter so it profited from the rise in oil prices resulting
in1973-74
 Mexican state owned and controlled oil the industry, revenues from sales went
directly to the government
 US bankers viewed the country as a safe place to lend money to
 Gov’t expenditure increases led to huge fiscal deficit and high economic growth
Second oil shock of 1979
 Industrialized countries reduced their dependence on imported oil so they were more
responsive to the rise in oil prices (more elastic)
 Worldwide recession led to further decline in demand for oil
 Mexico’s relatively high inflation rate made the peso, which was pegged to the US
dollar, increasingly overvalued
 Plus the huge fiscal deficit and decline in oil export revenues made the current
account move into a large deficit (12.5% in 1981)
More troubles
 The peso was overvalued and it led to speculation that it would be devalued. This
meant huge capital outflows and a fall in the reserve holdings of Banco de Mexico
 To reduce the CA deficit, the peso was devalued in 1982 but the government failed to
adopt other measures to control the deficit such as reducing its fiscal deficit and
monetary growth rate
 The main effect of the devaluation gives an additional boost to Mexico’s inflation rate
 The deteriorating position of Mexico’s economy and lack of confidence in the
government’s resolve to reduce its budget deficit made international bankers reluctant
to give loans
 Mexico’s debt repayment kept increasing and its ability to pay back was undermined
by its reduced export earnings, leading to a further speculation against the peso and a
run on the Banco de Mexico’s reserves
To stop the crisis from developing, on 12th August 1982, the Mexican government
announced a moratorium on its debt repayments until a satisfactory arrangement could be
drawn up with its creditors
 Requested new loans from foreign government and rescheduled its principal
repayments, requested for loans from the IMF
15.10 The Dimensions of the Debt crisis
12 August 1982
 Mexican government could no longer meet financial obligations of its $8 billion in
foreign debt
 Lenders (mainly banks) saw similarities between Mexico and other Latin American
countries
o No new loans and demanded repayment of earlier loans
 Many LDCs could no longer meet debt obligations
 Debt crisis
International dimension
 The real fear of both banks and authorities in industrialized countries was that if
Mexico went into default, they would be followed by other debtors
 Banking giants (e.g. Citicorp) were heavily involved: Bank loans to LDCs > bank
equity value
 A default by any of the big four debtor nations could easily have set off a chain
reaction of banking failures and provoked a collapse of the banking systems in the
developed countries
 Note: reasons for over lending:
 Banks underestimated the riskiness of investment projects – there were clear laws in
their credit-rating procedures, miscalculated the impact of world recession and rising
interest rates on the position of the debtors, banks in the debtor nation would not be
allowed to go bust by national regulatory authorities so this reduced their perceived
risks
 Banks participated in various syndicated loans to reduce risk exposure to default on
one loan
 If debtor country defaulted, then large banks would go bankrupt: world financial
system would collapse
15.12 The economics of default
It happened in the crises with regard to the course of the disease; Over-obligations are not
responsible for paying payment obligations. What stopped the countries with major financial
problems and standard? The consequences of a default are, in the long term, very detrimental
to an economy. Borrowing will be made very difficult during the break, in the practice of
possessions abroad. Note of a standard could be if the costs of the standard are less than the
revenues.
If the flow of capital from the debtor to the creditor is greater than the other way around, then
the standard benefit is to extract (in the short term).
15.13 – The role and viewpoints of the actors in the debt crisis
International banks that lent the money had differing degrees of exposure, faced different
regulator and tax regimes. Debtor nations also had differing degrees of indebtedness,
repayment burdens and prospects with regard to debt repayment.
Four major actors:
1. Commercial banks
 Immediate reactions to the debt problem was to view it as a ‘liquidity crisis’
 First: believed that debtor nations were finding themselves in short-term difficulties
(high interest rates, large amount of principal repayments falling due)
 Early solutions: to restructure the debtors’ repayments, giving them more time to pay
 Onset of the crisis: banks were reluctant to extend new funds, however they realized
that without new loans the incentives for debtors to default would rise: so
restructuring packages include further lending to avert default
 Opposed to granting debt forgiveness
Giving forgiveness to one country would lead other debtors to see similar relief
Debt relief might discourage the debtors from taking necessary measures to improve
their condition
 Granting a country a degree of debt relief would brand it as uncreditworthy so that
new loans to the country would dry up
 Argued to treat each debtor on a ‘case-by-case approach’
1. National authorities
 Primarily concerned to avoid a calamitous collapse of their banking systems which
would result from a default by one of the major debtors
 But they were extremely wary of utilizing public funds to ease debtor’s plight – did
not want to be seen ‘bailing out’ commercial banks whose lending had gone bad
 General feeling: further loans by authorities would not help when the problem of the
debtors was having too much debt already
 Most authorities (US administration) were prepared to allow tax concessions for the
provisions that banks made against possible losses on their lending
 Authorities were prepared to increase the amount of capital available to the World
Bank and IMF for lending to developing countries
1. IMF and World Bank
 WB: very concerned about the size and extent of debt crisis, and particularly the costs
in terms of slower development that debt repayments impose upon debtor nations
 IMF: main role was to ensure debtor nations that came to it for assistance adopted
tough economic measures required to improve their longer-term ability to service their
debt
 To ensure that creditor banks continued sufficient new lending to the debtor nations to
make it worthwhile for the debtor nations to accept an IMF-sponsored adjustment
package
 The World Bank had to be careful not to undermine its AAA credit rating by overextending itself to the SIMICs, while the amount of short-term finance provided by
the IMF was quite limited compared to the extent of the debt crisis
1. The Debtors
 Viewed the crisis as resulting from a combination of external factors beyond their
control
 Felt that creditor banks should allow some degree of debt-forgiveness in the form of
reducing the stock of debt owed by the debtors and/or reduced interest rate
repayments below market rates
 Argued that debt forgiveness is an incentive to make economic adjustments, improve
economic performance so that they can pay off their debts
15.14 The management of the debt crisis
 Goal: Avoid defaults (and collapse of world-wide banking system). Debt crisis
managed on a case-by-case basis.
 Advantage: prevent the formation of a debtors cartel that would have resulted in
increased bargaining weight of the debtor nations.
Crisis management can be split into 3 phases:
1. Crisis is viewed as a temporary liquidity problem
2. Try to grow out of debt problem
3. Crisis is viewed as a solvency problem
Phase 1: crisis is temporary liquidity problem
 ‘Temporary’ because debtors were just facing problems from rise in US interest rates
and a squeeze on export earnings


Rescheduling of debt repayments falling to give debtors time and prevent the threat to
the financial stability of exposed banks
 Short term debt rescheduling packages: short term maturity structure on rescheduled
debt, banks only lent money so that debtor countries could continue to service their
debt (pay back debt with more debt)
Large role of IMF: conditional debt rescheduling packages
 Let debtors restructure: devaluation, deflation, deregulation
 Apply tight monetary and fiscal targets to squeeze AD
 One of devaluation of real exchange rate to improve international competitiveness to
improve CA balance
 Reduced trade protectionism, privatization of state-owned industries, removal of
interest-rate ceilings to generate higher real rates of return: good for allocating scarce
capital and promoting domestic savings
 Convince banks to lend money, so that debtors can service their debts:
 IMF coordinates to avoid free riding by individual banks (this exemplifies the
usefulness of policy coordination; see chapter 14)
Result:
Defaults avoided! But sill large debt
These measures are costly in the short-term: low or negative economic growth: increased
unemployment, rises in the prices of basic commodities .
Phase 2: grow out of debt problem
 Simulate growth to reduce debt/GDP
Baker envisaged debtor nations ‘growing-out’ of their debt problems.
Approach of Baker plan (1985)
 Market-based structural reforms (trade liberalization, cuts in government expenditure,
relaxation of regulations relating to inward foreign investment)
 More IMF lending to stimulate structural adjustment
 Stimulate new lending by banks ($10 billion increase in lending by multilateral
development banks)
Result:
Not successful:
 Reforms and growth stagnated (in Mexico, Brazil and Argentina)
 Inflation rocketed
 Current account performance stabilized but their rates of economic growth, levels of
investment to GDP and trade volumes all experienced a slowdown
Failed because
 Low officials and bank lending
 Little incentive for banks to extend further new loans
 Little incentive for debtors to take new investment since any improved
economic performance would result in increased payments to creditors banks
 Dispute with IMF with its stabilization programs
Phase 3: Crisis is solvency problem
 Forgive debt
Shift from Baker to Brady
 Creditor banks sell outstanding loan assets to other commercial banks at a discount,
this created a secondary market
 The rising discount was due to a Brazilian moratorium on its debt repayments: debt
crisis would be difficult to resolve without debt reduction
 Citicorp announced it was setting aside $3 billion to its loan-loss reserves against its
lending and others follow suit with their own provisions

However, this does not reduce the contractual obligations of the debtors to repay their
debt
Crucial role by US Treasury: Brady plan (1989)
 Debt forgiveness is important (in addition to existing policies and market based
reforms)
 World bank and IMF should set aside funds for debt-service reduction aimed at
SIMICs with high external debt problems and undertaking appropriate adjustment
programs: also banks started to forgive debt
Result:
Successful: due to a perception on the part of debtor nations that there was a more equitable
sharing of the debt burden between themselves and creditor banks
 Willingness to pay was low compared to the ability to pay because debtors see the
adjustment packages as an unfair burden so with the Brady plan, debt forgiveness
raised the willingness to pay, which raised their ability to pay
 Venezuela, Mexico, Brazil and Argentina have ‘debt intolerance’, their governments
like to boost public and private consumption that capital inflow can bring but dislike
the debt-servicing payments in the long run – not willing to make necessary sacrifices
 Brazilian deal: negotiators set an effective limit to the new money option; the
Argentinian deal ruled out the new money option completely; and considerable moral
persuasion was applied to the creditor banks in the Mexican case
 Effects of Brady Plan: significant return of private capital into each of the big four
debtors and increase in the value of secondary market prices on outstanding debt
Crisis was largely resolved by 1995, but external debt problem is still relevant for many of
the countries involved (e.g. Argentinian default in 2002)
15.15 An overall evaluation of the debt crisis management
Cline (1995): three main objectives of debt-crisis management
1. Avoidance of a financial crisis and the collapse of international banking system
2. Restoration of capital-market access for debtor countries
3. Minimizing the economic adjustment costs for debtor nations
 Initial crisis management: ‘involuntary’ lending prevented outright default and
provided time for banks to build up capital reserves
 However, debtor countries should have been granted debt forgiveness earlier but
banks were in no real position to consider it because it may have increased eventual
write-offs and delayed the adoption of sound macro policies
 Majority of the burden was placed on debtor countries and fairer sharing of the burden
would have been appropriate because the crisis was due to excessive lending by
commercial banks
 Majority of banks voluntarily accepted principal and/or interest rate reduction at
lower rate on secondary market price of debt during the crisis – seen as sharing of the
burden
 Role of the IMF and World Bank has been criticized as being too biased in favor of
creditors and requiring too heavy an adjustment by debtors – investment in Latin
America stagnated and per capita incomes were lower
 However, IMF played a crucial role in coordinating banks and its stabilization
programs were important to successful resolution of the crisis
 Case-by-case approach was justified but this meant that IMF stabilization programs
should have exhibited a greater degree of variety than the standard package of
deflation, devaluation and deregulation
 Greater recognition that there was a large degree of interdependence among debtor
nations

E.g. during 1981–85 Latin American export volumes rose 25% but the deterioration in
their terms of trade meant that their export earnings remained stagnant
Argentina
Debt forgiveness is the bottom-line although it rewards bad behavior, it could help solve the
crisis and avoid the contagion effect
15.16 Post-Brady Plan crises in three of the countries
 Even though the Brady Plan was a success: the restructuring plan coincided with the
ability of the international banking system to write down and restructure much of the
debt on its books, and access to international capital markets was also restored to
many of the debtor nations.
 However, it is less clear that the problem of debt build-up and debt-service was fully
dealt with:
 Level of indebtedness of the big four debtors has continued to rise
 Their economic growth rates remained volatile
 Significant post-Brady crises in three of the countries: Mexico in 1994/95, Brazil in
1999, and more recently Argentina declared the largest-ever default on its external
debt obligations in January 2002, at the same time as it ended its currency-board link
to the US dollar.

Chapter 16: European Monetary System and European Monetary Union
16.1 Introduction
On 1 January 1999 EMU was finally realized in Europe when 11 founding countries (Austria,
Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal
and Spain) agreed to fix irrevocably their exchange rates with no margin of fluctuation and to
replace their national currencies with a new European currency called the euro.
16.2 The snake in the tunnel
Growing concern of countries allowing their exchange rates to be determined solely by
market forces as it could undermine the development of free trade within the European
Economic Community EEC) so the EEC members set up the ‘snake in the tunnel’.
On April 1972, made up of 6 EEC members
Member currencies could vary by a maximum of ± 1.125% against each other (the Snake)
they could float by ± 2.25% against the US dollar (the Tunnel). Smaller margin of fluctuation
for the member currencies then for the US dollar.
 Snake was characterized by a series of devaluations and revaluations
 Failed to produce the necessary degree of coordination of economic policies and
convergence of economic performance required for its successful operation
16.3 The background to the EMS
1978: EMS was created to replace the Snake
 Yao-su-Hu (1981): based upon a convergence of interests among the EEC countries
with regard to a common dollar problem
 Under Bretton Woods, dollar was the major international reserve currency for
exchange market interventions, etc. He argues that USA was free to run BoP deficits
to supply the world with dollars. When Nixon suspended dollar convertibility into
gold in 1971, it caused economic and financial losses for Europeans
Dollar problem
 Dollar was pegged by foreign central bank purchases, rapid growth in world money
supply, worldwide inflation
 Depreciation of dollar meant huge losses for central banks who bought them under the
Bretton Woods system
The desire to provide a stable framework for the conduct of European trade
 Since the adoption of floating exchange rates in 1973, there has been divergent
economic performances, which could threaten intra-EEC trade
 Hoped that stabilizing European currencies would lead to greater convergence of
economic performance and continued growth of European trade
EMS started on 13 March 1979
Goal: zone of monetary stability (exchange rate stability, low inflation)
3 main features
1. Exchange rate Mechanism (ERM)
2. European currency unit (ECU)
3. Financing facilities
16.4 The ERM
Parity rate for each bilateral exchange rate: grid of parities
Exchange rate band: actual rate within ±2.25% around parity
Usefulness: CB “borrows credibility” from Buba to reduce inflation
Explanation relies on: high p dot and fixed S, less competitive, unemployment increase
So: by fixing exchange rate, the cost of inflationary policy is high
 CB convinces market that it really wants to lower p dot: Ep dot goes down
 Actual p dot goes down
Realign if necessary: if pdot > p* for a long time, then devalue H to restore competitiveness
Two parts:
1. Grid of bilateral exchange rate bands between each of the member currencies which
defined obligatory intervention
2. Within bilateral margins authorities could intervene if they wished, intra-marginal
intervention, either in EMS or non-EMS currencies
3. Once two currencies reached a bilateral exchange rate margin, authorities were
obliged to intervene or take policy measures to keep currencies within their bilateral
limits
4. Intention: obligatory intervention should take place in the relevant EMS currencies
rather than in US dollars
5. Any changes in the grid of the central rates required ‘mutual agreement’
6. Individual band of fluctuation for each currency against the ECU, ECU = artificial
currency based upon a calculation of a weighted basket of 12 European currencies
Success:
 Exchange rates were quite stable
 Lower inflation for Italy, France
But ERM crisis in 1992-1993: speculators sold weak currencies, exploiting capital mobility
 bands widened to ±15% around parity from 1993
 de facto end of ERM
16.5 The ECU and its role as an indicator of divergence
ECU: weighted basket of 12 member currencies and acted as an ‘indicator of divergence’
 ECU would single out the currency that was diverging from the average agreed
parities before obligatory bilateral exchange rate margins was reached
 Act as an alarm bell – once a currency crossed its divergence threshold, authorities of
diverging currency were expected to take measures to bring its currency back into line
 Actions consist of a change in interest rates and/or in the monetary/fiscal policy
pursued by the country. Unlike reaching a bilateral exchange rate limit, triggering the
ECU alarm bell did not lead to obligatory intervention, only the expectation of a
change in policy stance
In practice, the divergence indicator did not necessarily work as intended E.g. - it was
possible for four high-weighted currencies in the ECU basket to appreciate against weaker
currencies in the system but keep their same central rate against each other
16.6 Financing facilities and monetary cooperation
Each member deposited 20% of its gold dollar reserves in the EMCF in exchange for the
equivalent value in ECU, idea that authorities use ECUs rather than dollars for their exchange
market interventions.
Important feature: members had access to credit facilities enabling deficit countries to
defend their exchange rate parities and manage transitory BoP problems:
1. Very short term financing: participating central banks granted to one another,
designed to ensure that EMS members who found their currencies under pressure had
necessary short-term support to intervene to defend their currency
2. Short-term monetary support: intended to meet financing needs in instances of
temporary BoP problems
3. Medium-term financial assistance: provided credits for participating countries
experiencing or seriously threatened with difficulties with their BoP over the mediumterm
16.7 An assessment of the EMS; and 16.8 The EMS as an anti-inflation zone
Two areas:
1. Exchange rate stability
2. Anti-inflation zone
Exchange rate stability
 Strain brought on by German reunification led to high German interest rates which
meant that interest rates of other European countries were forced to go higher in order
to maintain their exchange rate parities
 Many European economies were in recession, speculators became increasingly
skeptical about the commitment of governments to defend their exchange rate parities
through high interest rates
 French referendum on Maastricht Treaty on 1992 led to speculative pressures of the
Italian lira and pound sterling
 Exchange rate tensions caused the bands to be widened from +2.25% to +15%
 Cheung et al. (1995) have shown that most realignments in the ERM can be
characterized as attempts to restore international competitiveness
Both nominal exchange rates and real effective exchange rates had become less volatile for
EMS currencies than for non-EMS currencies since 1979 compared with the first 6 years of
floating. EMS had led to greater convergence of inflation rates.
Artist and Taylor (1994): Greater stability of exchange rates was accompanied by increased
stability of domestic short-term interest rates for ERM countries, countries derived both
greater domestic and external financial stability.
Non-ERM countries experienced both greater exchange rate and interest rate volatility post1982.
The EMS as an anti-inflation zone
Before: widely held belief that German inflation had generally been lower than that of other
EU countries because of the independent status of the German Bundesbank.
Advantages:
 Participation enabled relatively high inflation countries (Italy, France) to reduce their
inflation rates more rapidly, substantially and at lower cost than if they had been nonmembers
 Two ways the fight against inflation was assisted by EMS membership
 Giving authorities an incentive to bring inflation under control
Italy and France by making a commitment to peg their nominal exchange rates against
the Deutschmark pledged to bring their inflation rates down to German level
 Affecting private agents’ wage and price behavior
 Economic agents in France and Italy learned that persisting with high wage and price
inflation demands made their economies uncompetitive, job losses, economic
slowdown, workers had incentive to lower wage demands, therefore lower inflation
 Membership of ERM assisted in the process of bringing down inflation compared to
non-ERM membership. Italian and French authorities by being members of the ERM
were, according to anti-inflation hypotheses, able to bring down their inflation rates
more substantially and more quickly than could have been achieved without
membership
 Main gain for Germany: improvement in international competitiveness due to the
resulting real depreciation of the Deutschmark
Starting from a similar average inflation rate in 1980, the inflation rate in the non-ERM
countries was lower than in the ERM countries up to 1985. Only during 1986–91 did the
ERM countries have a lower inflation rate; between 1992 and 1998 the non-ERM countries
generally had an even lower average inflation rate.
Susan Collins (1988): found only limited and inconclusive support for the hypothesis that the
inflation rate had come down more significantly for the EMS countries for the whole of the
period.
Lack of conclusive support for the anti-inflation hypothesis: for the first 3 years of its
operation, it is a seriously defective description of the EMS.
Differential effects of the second oil shock made authorities very reluctant to accept the
discipline of the system.
Only after 1982 did policy makers in France, Belgium, Denmark and Italy decide to subject
their economies to disinflationary policies, rapid decline in EMS inflation rates and a greater
convergence as compared to the group of non-EMS currencies.
16.9 Intervention policy in the EMS
Bundesbank:
 Generally very active with regard to non-obligatory intra-marginal intervention
 However, at times, particularly when the system was on the verge of realignments, it
was prepared to engage in heavy obligatory marginal intervention
 Far more active with regard to the dollar exchange rate (large seller when
appreciating, purchaser when it fell)
 Other ERM countries were far more active with regard to intra-marginal intervention
and keeping their currencies in line with the Deutschmark
Bundesbank typically sterilized its interventions so that they did not affect the German
monetary base, purchase or sales of foreign currency that increased or decreased the German
money supply were typically offset by sales or purchases of domestic bonds so as to
neutralize the effect on the German monetary base.
 Other EMS countries normally only engaged in partial sterilization, so that the
purchases or sales of foreign currency resulted in expansion and contraction of their
domestic money supplies
Overall picture:
 Bundesbank managed the external exchange rate of the ERM currencies against the
dollar
 Rest of ERM members took responsibility for ensuring that they kept their exchange
rates in line with the Deutschmark
 Bundesbank did not allow its exchange rate policy to influence its money supply and
its primary objective of domestic price stability by pursuing sterilization policy

ERM countries accepted the discipline of the system by purchasing their currencies
when they were weak to keep them in line with the Deutschmark and permitting this
intervention to result in a contraction in their money supplies
16.10 The economic performance of ERM and non-ERM countries
ERM succeeded in its aim of becoming a zone of currency stability, but there was
disagreement over the benefits or otherwise of full EMS membership. Membership helped in
fight against inflation, may have been at the expense of countries having to adopt deflationary
policies leading to lower economic growth and higher unemployment.
16.11 What is meant by economic and monetary union?
Slide: Why from EMS to EMU
Single currency would enhance market integration.
EMS had become too asymmetric:
 Bundesbank focused on German economy (internal balance, IB)
 Non-German CBs followed Buba (external balance, EB)
 Symmetric EMU would focus on all members.
Capital mobility & “fixed” exchange rates
 danger of speculative attacks
 single currency would avoid that
Step towards political unification: perhaps main argument.
 EMU would have additional benefits (but also costs; see below).
Two components:
1. Monetary union: exchange rate union
2. Fixed exchange rate, no fluctuations, creation of single currency
3. Fully integrated financial markets
4. Complete capital market integration:
5. Common market
6. Free internal movement of goods, services, people, capital
7. Common external regulations of goods, services, people, capital
8. High coordination of economic policy regarding
9. Competition, structural change
10. Macroeconomic policy
11. Regional development
Implicit requirements:
 Members of the union harmonize their monetary policies
 Different monetary growth rates would lead to differing inflation rates
 When a single currency is brought into circulation, it requires a union central bank to
control its supply and manage the exchange rate and this central banks requires a pool
of exchange reserves
Differences monetary union from fixed exchange rate system:
 Monetary union:
 Permanent commitment to peg the exchange rate, creation of a single currency
 Requires a well-developed institutional framework
 Financial capital must be allowed to move freely between members
 Fixed exchange rate systems allow for occasional realignments and usually permit
margins of fluctuations around a central rate
 Has capital controls
16.12 Benefits of economic and monetary union; and 16.13 Costs of EMU
Benefits:
 Removal of trade barriers, increasing the volume of intra-EU trade, rise in the
economic prosperity of its members
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To maximize trade flows, you need to have a common medium of exchange, adverse
effects of medium to long-run exchange rate uncertainty would be eliminated
Elimination of transaction costs (of converting different currencies)
More efficient allocation of labor and more efficient allocation of capital, due to
removal of capital controls
Before: capital controls restricted capital from moving to countries where it has a low
marginal productivity to instead move to countries where it has a high one
Elimination of exchange rate controls and uncertainty created by exchange rate =
more efficient allocation of capital
Wages and salaries expressed in common currency = better allocation of labor
Euro will fluctuate less against third-country currencies, less need to hold foreign
exchange reserves. Euro will become a world currency, leading to an increase in the
European currency component of non-EU countries reserves
Savings in administrative costs for businesses
No need to monitor exchange risk
Greater liquidity and rationalization of financial markets
Debt of member countries are denominated in euros, gov’t bond markets more liquid
Company stocks in euros, more equity business done on most efficient exchanges
Greater price transparency
Difficult for manufacturers to maintain price differentials in different markets, benefit
consumers
Costs:
Economic stability loss
If asymmetric shock but no action at union level, while national CB wants to stabilize
output, no room for an increase in money supply and exchange rate devaluation
policies
 Loss of monetary autonomy
 A common interest rate may be insufficiently high to reduce economic activity in
booming countries while being too high to help countries in recession
 Loss of national macroeconomic policy autonomy
 Monetary union requires common inflation rates, countries with differing preferences
to any unemployment-inflation-trade-off will have losses because of monetary union
 Loss of inflation tax
 A lower tEMU inflation rate implies a smaller inflation tax revenue for high-inflation
countries, meaning that their governments will have to replace the lost inflation tax
with explicit direct and indirect taxes
 Italy and Spain are heavily indebted countries, the temptation to inflate and reduce
real value of outstanding debt was higher
 Regional disparities
 Labor that leaves low productivity areas is usually the most mobile and productive
part of the region’s workforce
 Loss of the exchange rate policy instrument
 Some countries experience persistent deficits and others surpluses, loss of exchange
rate policy instrument is applicable to individual Eurozone countries
 Transaction costs
 Calling in existing national notes, printing of new notes, education and training,
altering automated telling and vending machines, but future benefits economies of
scale from manufacturers dealing with one currency
Definition:
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Optimum currency area (OCA) is a region where economic efficiency would be maximal if a
single currency was used. OCA theory analyzes when a country should join a common
currency. Main point of theory: costs and benefits of MU depend on INTEGRATION.
16.14 A history of the road to EMU
Integration started after WW II
Process launched on 9 May 1950:
France proposed
 Creating the “first concrete foundation of a European federation”
 Creation of a European coal and steel community
Main reason: reconstruction in Germany should not endanger peace
 Focus on two sectors for defense industry (coal and steel) and run them under a
common management
Treaty of Paris (1951)
 Established the European Coal and Steel Community (ECSC) – Belgium France
Germany Italy Luxembourg Netherlands
Treaty of Rome (1957)
Aimed at the creation of a customs union which involved the adoption of a common tariff
policy vis-à-vis third countries and the removal of trade barriers between member countries.
Creation of
 European Economic community (EEC): aiming at common market
 European Atomic Energy Community (Euratom)
Notes:
 EEC was most important one of the three communities (ECSC, EEC, Euratom)
 Three communities merged in 1967: European Communities
 Later called the European Community (EC)
 Since Maastricht Treaty (1991): European Union (EU).
On monetary issues:
 Exchange rate policies are a matter of “common concern”
EMS & Delors Report: emphasized the need not only for convergent monetary policies, but
also for convergent fiscal policies. Argued that the monetary union requires a single currency
rather than just
irrevocable fixed parities. Would demonstrate the irreversibility of the move to the EMU,
would facilitate
monetary management, and avoid the transaction costs of converting currencies.
Necessary: EU central bank, full liberalization of capital markets and financial market
integration
Stage 1: the convergence phase
 Providing the necessary foundation upon which to build EMU
 Greater convergence of economic performance
 Enhancing economic and monetary coordination amongst member states
 Main features:
 Completion of the single market project
 Strengthening of community policies to iron out regional imbalances
 Greater cooperation and coordination of monetary and fiscal policies
 Removal of obstacles to financial integration
Stage 2: the transition phase
 Aimed at ensuring the readiness of national economies for the eventual permanent
fixing of exchange rate parities: Maastricht treaty
 Establishment of European Monetary Institute (EMI) to prepare the groundwork for
the implementation of the final phase
Assist progress on economic convergence by strengthening coordination of monetary
policies between EU central banks, ensuring price stability
 Make preparations for the final phase, statute of the central bank
 ESCB: begin the transition from the coordination of independent national monetary
policies to the formulation and implementation of a common monetary policy
Stage 3: the fixing and euro phase
16.15 The Maastricht Treaty
The Maastricht Treaty (1991)
A collection of additions and amendments to the Treaty of Rome, covering political and
economic reform. Provided legal basis to establish the institutions required for EMU, the
ECB. Set out conditions under which a country would be eligible for joining EMU.
Treaty specified timetable for 3 stages towards single currency. Most important deadline:
stage 3 of EMU euro stage) should start on 1 January 1999 at the latest, deadline met
4 criteria of convergence to joining EMU (if country meets them, then it must enter stage 3)
Goal: ensure that economic development within EMU is balanced and does not give rise to
any tensions between the member states
 Low inflation: average consumer price inflation should not be more than 1.5% above
that of the three countries with the lowest inflation rates
 Low long-term interest rates: should not be more than 2% above that of the three
countries with lowest inflation rates
 Government budget deficit <3% of GDP
 Government debt <60% of GDP
 Currency of a country was expected to have respected normal margins of fluctuations
and not have been devalued within the ERM in the 2 years prior to a country joining
the EMU
 UK negotiated an “opt-out”: not obliged to enter stage 3
 Denmark decided not to join stage 3
16.16 An evaluation of the Maastricht criteria
The Germans were keen to exclude countries with poor economic record and a high
propensity to print money when faced with economic difficulty (such as Italy and Greece) to
ensure the euro would be a sound currency like the Deutschmark.
Criticisms on the Treaty:
 Arbitrary both in relation to the targets set and the targets chosen like 3% of budget
deficit to GDP ratio and 60% of government debt to GDP ratio, countries were
massaging their fiscal deficits to meet criteria
 National debt criterion was not really appropriate since it only looked on the liability
side, ignoring state-owned assets, country can have high national debt but high stateowned assets, and thus has low net liability
 Countries like Italy and Belgium would have less of a public debt problem and lower
fiscal deficits if they were allowed to join the EMU, high government debt countries
could more easily meet the Maastricht conditions as members of EMU than if they
were excluded
 Lower interest rates as part of the EMU would enable them to lower their fiscal
deficits since they would reduce the financing cost of national debt (rather than pay
higher interests since markets feared they would resort to printing money)
 Convergence criteria are not really that important and distract attention from more
important fundamental clauses
 ‘No-bail-out’ clause was unnecessary since each government that joins EMU is
responsible for its own debt
 Plenty of ‘before’ conditions but no ‘after conditions’
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16.17 The Stability and Growth Pact (SGP)
Main points:
 Medium-term budgetary stance “close to balance or surplus”
 SGP designed to ensure that fiscal prudence remained in place following the start of
EMU
 Penalties if deficit >3% of GDP unless actions to reduce deficit
 If council believes deficit is excessive and recommend member states to take
corrective action within 4 months, if insufficient, member state must make a noninterest rate bearing deposit with the ECB ten months after notification
 The maximum penalty in any one year is 0.5% of GDP, in the first year the deposit is
a fixed portion of 0.2% of GDP and a variable portion of 0.1% for every 1% above the
3% threshold
Why needed?
 To obtain fiscal restraint once countries are in the EZ
 Achieve low inflation and avoid weak euro
 To avoid pressures on ECB to finance government debt
 Avoid money growth and inflation
 To ‘sell’ single currency to German public
16.18 The changeover to the single currency
3 periods for transition
 First period
 On May 1998, the selection of the countries that met the Maastricht criteria and are
eligible to join EMU
 Second period
 On January 1999, permanent fixing of the bilateral rates between the member
currencies and announcement of their conversion rates to the euro
 EMI liquidated and replaced by ECB and ESCB
 ESCB: conducts single monetary policy and maintain price stability by setting shortterm rates for euro, responsible for money-market and foreign-exchange operations
for euro
 Third period
 On January 2002, introduction of euro banknotes and coins alongside existing
national notes and coins for six months, both legal tender and anyone was able to
exchange on demand at commercial banks their national currency for euros, July
2002, national notes stopped being the legal tender
1998 examination
11 countries passed:
 Inflation had converged a lot, e.g., Italy & Spain from 6% in 1991 to 2% in 1998
 convergence before MU proved to be possible
 Interest rates had converged
 Deficits: OK
 Debt ..... countries were saved by Belgian clause
 “ignoring” 60% is one of reasons for Eurozone sovereign debt crisis
- ERM membership: OK
- Greece failed: had not converged enough (joined in 2001)
- Sweden failed: not in ERM (“diplomatic” or “de facto” opt-out)
- UK and Denmark exercised their option: no euro
16.19 The performance of the euro in the foreign exchange market
Euro came into existence: its parity is approximately $1.17/€1, many economists expected it
to strengthen. However, euro decline against the US dollar in the foreign exchange market, as
low as
$0.82/€1. But in 2002, it made a recovery, rising to as high as $1.58/€1 in forex market in
2008. Since financial crisis and Eurozone crisis, euro exhibited more weakness and by June
2012: $1.25/€1.
16.20 The euro system
 Comprises of ECB and 17 national CBs
 Governing bodies:
 Executive Board
 President, Vice President, 4 ECB directors
 implement decisions taken by governing council + giving instructions to 17 NCBs
 Governing Council
 Executive Board + 17 Governors of NCBs
 main decision main body + formulate monetary policy
 main policy decision: to set the refinancing rate (interest rate at which it will provide
liquidity to the banking system in exchange for eligible reserves such as eurodominated Treasury bills)
 Modelled on German Bundesbank
 Statutory duty to ensure price stability: aims at inflation rates of below, but close to
2% over medium term: in practice: can exceed 2% in short run
 Political independence is guaranteed and prohibited from printing money to finance
any member state’s fiscal deficit
16.21 Failure of Stability and Growth Pact
 Suppose to act as a constraint on fiscal deficits post-EMU
 German and French fiscal deficits exceeded SGP requirement, both should be fined:
both countries succeeded in blocking such attempt
 Failure to enforce SGP on big countries and a feeling that SGP imposes harsh fiscal
conditions for countries that need to stimulate their economic growth by running
larger than 3% fiscal deficits: debate on reforming the SGP, suggestions:
 Country that has low level of national debt is permitted to have larger than 3% fiscal
deficits
 Raising fiscal deficits from 3% to 4%
 Permitting it to average 3% over one economic cycle
16.22 ERM II
 Key features:
1. It is based on central rates fixed for participating currencies vis-à-vis the euro and
therefore has no parity grid – the normal band of fluctuation being around 15%
2. There exist obligatory interventions once margins are met
3. The ECB and all participating “pre-in” CBs have the right to initiate procedures to
review the central rates
4. Access is provided to short-term financing facilities with the ECB having the right to
suspend intervention and financing operations
 A country that joins ERM II can request for lower margin of fluctuation, for
Denmark: 2.25%
 New accessing countries are expected to spend a minimum of 2 years in ERM II
before their adoption of Euro
16.23 PIIGS and eurozone crisis
 UIP: very short-term interest rates, e.g. 3-month Treasury Bills, will be equal in a
monetary union since the expected change in the exchange rate is 0 (as they have
same currency), this is not the case for long-term bond yields within a monetary union
because they cannot just print money to redeem their debt, investors have to count the
possibility that these countries may default: difference between inflation risk and
default risk
 Prior to the crisis, the premium of PIIGS debt over German ten-year bonds were
modest. But their high level of govt debt and widening of fiscal deficits made
investors worry they may default: speculative attack on PIIGS bonds
16.24 Bailouts of Greece, Ireland, Portugal, and Spain
Greece
 Bailout is a necessity:
 French and German banks held over 70% of the Greek Debt: Greek default would
have severely impacted the viability of French and German banking system
 Fear of contagion: If Greece defaulted, Portugal and Ireland could be defaulted, and
later “too big to rescue” countries Spain and Italy could default
 Background:
 was allowed to join EMU despite having a national debt of GDP ratio of 104,7%
rather than required 60% based on Maastricht Treaty
 Greek 10-year bond yields fell from 19% to 5.3%: Greek government used the low
yields to borrow even more
 Over-employment in public sector, poor system of tax collection, and culture of tax
evasion
 Problem of build-up of debt, fully exposed once the credit crunch got under way:
 rapid rise of unemployment, reduced tax collection, greater fiscal outlays
 large cumulative fall in GDP, fiscal deficit rose
 National debt as proportion of GDP rose rapidly due to a combination of high fiscal
deficit and falls in GDP
 1st rescue package (2010)
 110 billion Euro with yield of 5.2%
 Conditions: Rising VAT, Rise in fuel, alcohol, and tobacco duties, cuts in public
salaries and pensions
 To reduce risk of contagion: EU/IMF set up European Financial Stability Facility
(EFSF) to provide immediate liquidity for Greece, Ireland, and Portugal that would
help forestall further speculative attacks
 It became clear that the Greek level would need to be both reduced and restructured
 2nd rescue package (2012)
 Creditor banks were forced to accept substantial losses of 109 billion euros in order to
reduce Greek debt levels
 Convert existing bonds into 30-year bonds
Ireland
 Necessitated by the impact of credit crunch and ending of its housing bubble which
led to the virtual collapse of Irish banking system
 House prices started to fall and non-performing loans started to rise, Irish govt was
forced to step in and nationalize all besides one of the six major banks and guarantee
their deposits, raised the national debt and increase in its fiscal deficit, yield on bonds
rise
 Bailout package 2010
 89 billion euros
 Conditions: severe austerity program to reduce fiscal deficit from 31.2% to 3% of
GDP in fiscal year 2014, budget cuts and tax rises, wage and pension cuts, reduction
in minimum wage
Portugal
 Vulnerable because its national debt >85% of its GDP and high fiscal deficit
 Bailout package 2011
 78 billion euros
 Conditions: rises in sales, property, and health services taxes, cut in duration of
unemployment benefits, pension cuts, privatization of state-owned companies, highspeed rail project postponed
Spain
 Background: Spanish banks had extended loans to Spanish property sector,
construction boom and housing bubble
 When bubble burst, Spanish banks had a large amount of dubious loans, raising
probability of Spanish govt bailout of Spanish banks, Spanish govt bond yields started
to rise
 Fears for Spanish banking system rose because five of 27 banks failed the stress test
and a bank that was merged from seven weak banks collapsed. Spain agreed to accept
funding from EFSF of 100 billion euros in loans to recapitalize the banking system
16.25 The Covered Bond Purchase Program
European banks suffered as a result of the credit crunch that started in 2007 and were finding
it difficult to restore capital ratios as the credit markets had generally dried up for bank
funding. To help improve banks' access to funding, ECB purchases up to €60 billion of
covered bonds debt backed by pools of assets on both primary and secondary markets. Initial
covered bond purchase program completed by June 2010. However, due to problems from the
effects of the Eurozone crisis, a second CBPP program was announced, authorizing the ECB
to purchase another €40 billion of banks’ bonds by the end of October 2012. Aim of the
program: ensure medium-term funds for struggling European banks and improve liquidity in
the bank bond market.
16.26 The Securities Market Program
In May 2010, ECB established the Securities Market Program (SMP): allowed the SDCB to
‘operate in the financial markets by, among other things, buying and selling outright
marketable instruments’. Prime motivation: to contain the ever-rising bond yields on
Portuguese, Irish and Greek debt and then include Spanish and Italian debt.
What does it do:
SMP involved ECB purchases of PIIGS sovereign bonds on primary and secondary markets
to prevent the risk of Spanish and Italian debt yields rising to dangerously high levels and to
prevent bailout and the risk on the euro.
Under SMP: purchases of PIIGS debt were sterilized by offsetting sales of Treasury bills to
sterilize the impact of purchases on the European money supply (€22 billion of securities
were purchased).
Concern:
Buying large amounts of PIIGS debt meant the ECB was assuming the risk in the event the
PIIGS were to default, in the second Greek debt restructuring, the ECB was seen as a senior
creditor and its bond holdings were not subjected to write-down, this created more worry.
16.27 The Long-term Refinancing Operation (LTRO)
Growing concern of Grexit and of other countries, SMP were called into question,
appointment of Mario Draghi in 2011. LTRO: In 2011, ECB would lend some €489 billion of
funds for three years to European banks at an interest rate of 1%, 2012 – 800 banks borrowed
a further €529.5 billion.
LTRO ensured that no European bank would go under due to liquidity issues, funds invested
in government bonds so reduced Italian and Spanish bond yield. Funds were also used to buy
back existing bank debt, confidence grew which boosted stock markets however after Greek
election, the gains were wiped out in 2012.
Bad side to LTRO:
 Further monetary easing
 Subsidizing the banking sector
 Allowing insolvent banks that need nationalization and/or recapitalization to continue
to trade
 Delaying governments from undertaking fiscal reforms by indirectly and artificially
boosting demand for their bonds
 Exposed European taxpayer to significant risk of losses as the ECB increases its
exposure to European banking sector
Result: during credit crisis and Eurozone crisis: balance sheet of ECB expanded massively
from %1.138 trillion in 2007 to $2.980 trillion in May 2012
16.28 The Fiscal Compact
SGP had been unable to avoid bailouts
SGP strengthened again in 2011
E.g. excessive deficit procedure can be launched if:
 Deficit >3 % and/or
 Debt >60 % that doesn’t shrink fast enough (so “60 %” is part of SGP only as of
2011).
Fiscal Compact (FC) (2013) goes further than SGP:
Countries should write in national legislation:
 Govt. should run balanced budget or surplus
 Structural deficits (e.g., after cyclical adjustment) are max. 0.5% of nominal GDP, but
if debt <60%, then max. fiscal deficits of up to 1% of GDP
 Member states with debts above 60% of GDP will reduce these debts towards the
reference value
 If European Court of Justice can find a country that does not adopt a standardized
balanced budget rule, it can levy a fine of 0.1% of GDP
 Automatic action in case of deviation from objectives of ‘fostering competitiveness,
promoting employment, contributing further to the sustainability of public finances
and reinforcing financial stability’
Concerns:
 Pact requires too much fiscal austerity, especially as the global economy struggles to
recover from the credit crunch and Eurozone crisis
16.29 The European Stability Mechanism
ESM: Intergovernmental organization with a fund of €500 billion and it works in conjunction
with the IMF in any bailouts of Eurozone member states with strict conditions applied to any
loans.
Hope: by having a pool of money to bail out countries, speculators will become more wary of
launching speculative attack.
A eurozone country facing a short-term liquidity problem can apply for emergency funding
from the ESM provided it accepts the fiscal austerity program and related conditions that are
set out. However, if a member state’s debt position is regarded as unsustainable, it has to
enter negotiations with its creditors to restructure its debt as a condition for any bailout funds.
16.30 Outright monetary transactions
 Allow ECB to buy gov’t debt in the secondary market in unlimited amounts if
necessary, help lower bond yields in countries like Spain and Italy
 However, such purchases are conditional on countries adopting strict conditionality
with regard to fiscal policy under ESM and IMF program
Any OMT purchases, sterilized, for every €1 billion of gov’t debt purchased by the
ECB would sell €1 billion of securities, so no monetary base implications from the
program
 Any bonds purchased by the ECB under OMT, treated on an equal basis as other bond
holders
16.31 Proposals to resolve the European debt crisis
Motivation of proposals: desire to avoid risk of contagion that would result from a formal
default by one or more of the PIIGS
 Structural reform: To improve the competitiveness of their economies so they can
grow out of their debt problems
 Privatization
 Reduction of bloated public sectors
 Reduction in state benefits and entitlements
 Labor market reform (reduction in min. wage and trade union powers)
 Supply side measure: improve LR economic growth and fiscal dynamics
 Debt forgiveness/Restructuring: Lower debt service, the countries can grow more
rapidly, money used to improve infrastructure, education or health services
 Issuance of common E-bonds, E-bonds backed by all gov’t in EZ: Countries can
switch some of their existing debt for newly issued Eurobonds at a lower cost of
finance.
 Merit: It would create a very liquid market and more transparency in banks’ balance
sheets as those that chose to swap existing debt in the PPIGS at a discount to its face
value which would have safer capital on their balance sheets and actual losses would
be clearer.
 Disadvantage: countries like Germany may find the interest rate at which they
borrow to actually rise as their potential exposure to the PIIGS debt was factored in
by the financial markets.
 At odds with Maastricht no-bailout clause in that in part members would be jointly
and severally liable for the debts of other members and would require a revision to the
treaty
 Would require European level tax raising powers so that repayment of the bonds can
be guaranteed
 Allow ECB to print euros to guarantee debt repayment
 Reasoning: If national debts become unsustainable, EZ member countries have no
choice but to default, financial market participants tempted to make self-fulfilling
speculative attack.
 A banking union
 Heart of Eurozone crisis, banking crisis
 French and German banks accumulated large holdings of PIIGS debt, due to their
higher r
 PIIGS banks accumulated large holdings of their own gov’ts debt as capital reserves
 Credit crunch: PIIGS economic fundamentals deteriorated, PIIGS banks large losses +
losses on sovereign debt, bailout of the baking system in Ireland, Spain and Greece
became essential
 Should include:
 A European-level deposit protection, minimize risk of capital flight
 Common capital ratios and a common regulatory regime, to deal with problems of
insolvent banks, they can be recapitalized or shut down, give confidence to depositors
and financial market and reduce risk of contagion and unnecessary bank runs
 Agreed conditions for bailout funds

Deposit guarantee system: require a common funding based on a percentage of a
bank’s deposit base
16.32 The accessing countries and EMU
Eight Central Eastern European countries joined EU in 2004, and agreed to adopt the euro.
According to European Committee, monetary integration of new member economies into the
euro area should be multilateral, successive (staged) and phased (some join before others).
 They are also expected to achieve some convergence with the rest of Europe in their
process of economic development by speeding up the process of transition and
structural reform
Three phases:
First phase: pre-accession
 CEEC adopted removal of capital controls, making their central banks independent,
and prohibiting central banks from printing money to finance their fiscal deficits
 Free to pursue exchange rate policies at this stage
Second phase: access and then inclusion into eurozone
 States give up monetary autonomy, exchange rates, macroeconomic policies
 Avoid excessive fluctuations of currencies and misaligned exchange rates
 Spend two years with their currencies inside ERM II arrangement
Third phase:
 Meet criteria to join Eurozone
 Adopt the euro
 Stop using national currencies
 Have similar rights and obligations as other Eurozone countries
 Respect fiscal requirements of SGP and national central banks join ESCB
arrangements
Issues posed by increasing EMU membership
 Too-early an entry of weaker countries could reduce confidence in the euro
 Design of optimal monetary policy becomes more complicated for ECB
