Chapter 6:
The Fragility of Incomplete
Monetary Unions
De Grauwe:
Economics of Monetary Union
Incomplete monetary unions
• Incomplete monetary unions are arrangements
whereby the monetary authorities peg their
exchange rates
– Examples: the Bretton-Woods system and the ERM
• Over time most of these arrangements tend to
disintegrate after some crisis:
– The Bretton-Woods system collapsed in 1973
– The exchange rate mechanism (ERM) of the EMS
collapsed in 1993
– The South-East Asian currencies were hit by speculative
attacks in 1997-98
– Similar crises involved Latin American currencies in the
1990s
Why are pegged exchange rate
regimes to so fragile?
• The fragility of a fixed exchange rate system
has everything to do with credibility
• When the authorities announce a fixed
exchange rate they are making promise to keep
the exchange rate fixed today and in the future
• The problem with any promise is that doubts
may arise as to whether it will be kept
• Circumstances may arise in which the fixed
exchange rate arrangement ceases to be seen
as consistent with the economic welfare of the
country
• In that case the monetary authority will have
an incentive to renege on its promise
• Economic agents will suspect this and will
attack the currency
• A speculative crisis arises
Differences in reputation lead to low
credibility of a fixed exchange rate
• Barro - Gordon model is our framework for
analysing problems of reputation
Fixing exchange rate is not credible
Germany
Italy
p G
p I
E
G
B
p G
C
F
A
UI
UG
Fixing the exchange rate of the lira with the mark is not credible, because
Italian authorities have an incentive to create surprise inflation
(devaluation)
– In this model the high-inflation country (Italy) has a
lot to gain from pegging its currency to the currency
of the low-inflation country. It is borrowing
reputation
– Italy will find it difficult to fix its exchange rate
credibly
– The Italian authorities have an incentive to cheat (a
temptation) so as to reduce unemployment
– This temptation is larger the steeper is the
indifference curve (see previous figure), i.e. the
greater the weight the authorities attach to
stabilizing employment (or output), a domestic
objective
– The weight the central bank attaches to this
domestic objective is represented by 
Relation between the temptation of the central
bank to devalue and the parameter 
temptation

•Temptation, , = the benefit for the
authorities of devaluing, given that agents
expect that the central bank will never
renege on its promise.
•When >0 the central bank is tempted
to devalue
•This temptation increases with 
•This regime in which the central bank fixes
the exchange rate and then gives a nonzero weight to a domestic objective will not
be credible
•Rational agents will test the central bank
and attack its stock of international reserves
•Since most central banks give some nonzero weight to domestic objectives, fixing
the exchange rate will most of the time not
be credible (except if =0)
Fixed exchange rates are credible if
cost of devaluation is high
Figure 5.1
temptation

C0
0

•It is possible for the central
bank to combine fixed exchange
rates and credibility only if
devaluation is costly
•The cost is a loss of reputation
• By assumption this cost is fixed
( C0 )
•As long as < 0 the fixed
exchange rate can be made
credible, because the cost of
loosing reputation exceeds the
temptation to devalue
•Will this hold in all states of
nature?
Temptation curve, , as a function
of the size of the shock, .
temptation

C0
1
0

• is a shock in the Phillips curve
•When >0 Phillips curve shifts
upwards, creating unemployment
•The temptation to devalue
increases with the size of the shock
(upward sloping), for any given 
•As the shock becomes larger the
cost in terms of lost employment (or
output) increases increasing
temptation
•When the shock is zero (=0)
temptation is 1
•If this is smaller than C0, the fixed
exchange is credible
•When > 0 temptation exceeds cost
of devaluation; fixed rate looses
credibility
‘First generation’ models
(Krugman (1979))
• As time goes by, the probability that some
shock will exceed 0 is positive
• A sufficiently large shock will make the fixed
exchange rate non-credible
• Only if the central bank can make it clear that
it does not pursue any domestic objectives
(=0) can this problem be avoided
• Thus a crisis is inevitable if the central bank
pursues domestic objectives that conflict with
exchange rate commitment
‘Second generation’ models
(Obstfeld (1995))
• This model stresses that a country that
attaches a low weight to domestic objectives
and thus has a credible fixed exchange rate
can still get into trouble
• Assume that for some reason speculators
expect the currency to be devalued
• The authorities who want to maintain the fixed
exchange rate will have to defend it against
these speculators
• Such a defence is costly
• The central bank will be tempted to abandon
the peg
– We derive a second temptation curve ()
– This is the temptation to devalue when the authorities face
expectations that a devaluation will occur
–  increases with , i.e. the more the authorities care about
domestic objectives the greater is the cost of defence and
thus temptation
temptation


• Temptation curve  is located above the
temptation curve 
• This is due to an asymmetry
• The welfare loss from applying deflationary
policies to defend the peg in the face of a
speculative attack is greater than the welfare
gain obtained from the expansionary
employment effects of surprise devaluation
Temptation,
Cost of defence
Δ
Θ
C0
β1
β
Assume =1
There are two possible
expectations:
A) Speculators do not expect a
devaluation
•The temptation of the central
bank to devalue, , is lower
than the cost of a devaluation
•The central bank has no
incentive to devalue
B) Speculators expect a
devaluation
• The relevant temptation
curve is 
•The temptation to devalue is
larger than the cost of a
devaluation
•The central bank has an
incentive to devalue
• There are therefore two possible equilibria that
depend solely on the state of expectations
– When agents do not expect a devaluation the
authorities have no incentive to devalue so that the
exchange rate remains fixed
– When speculators expect a devaluation, the
ensuing speculative attack creates an incentive for
the authorities to devalue, and there will be a
devaluation
– In both cases expectations are model-consistent
(rational)
Temptation,
Cost of defence


indeterminacy zone
no attack zone
•Whether or not crises occur
depends on combinations of 
and C
•Three situations can occur:
–When  is low and C is
high, we are in the no
attack zone
attack zone
–When  is high and C is
low we are in the attack
zone
–There is an intermediate
zone (indeterminacy zone)
where the cost of
devaluation is intermediate
between the two
temptation curves

Policy Issue arising from greater
capital mobility
Temptation,
Cost of defence
Δ’
Δ
Θ
C1
C0
β
•When capital mobility increases:
•the temptation curve  shifts
upwards (from  to ’)
•Indeterminacy zone increases
•Fixed exchange rate becomes more
fragile
•Choice between more flexibility or
tighter discipline on fixed rates
•To keep the economy within the no
attack zone:
1)Increase the cost of devaluation
from C0 to C1
Example: Maastricht fixed exchange
rate condition as entry requirement
for EMU
2) Reduce the weight for domestic
objectives
The n-1 problem in pegged exchange
rate systems
• In a system of n countries, there are only n - 1
independent exchange rates
• Implications
– n - 1 monetary authorities have to adjust their
monetary policy instrument so as to maintain a
fixed exchange rate
– One monetary authority is free to set its monetary
policy independently
– Who will be the central bank that uses this degree
of freedom?
– Potential for conflict
Two-country model of the
money markets
• Country A
– money demand: MAD = PALA( YA , rA)
– money supply: MSA = RA+ DA
• PA price level of country A, YA output, rA, interest rate , RA
international reserves, DA credit to the domestic sector
• Country B
– money demand: MBD = PBLB( YB , rB)
– money supply: MSB = RB+ DB
• We assume perfect mobility of capital
• The (open) interest parity condition holds
– rA = rB + 
•  is the expected rate of depreciation of the currency of
country A.
• In a fully credible fixed exchange rate system:
= 0.
The n-1 problem in a two-country
monetary model
rA
r2
rB
Country A
Country B
G
H
E
r1
F
PBLB
PALA
M2A
M1A
MA
M2B
M1B
MB
•money demand downward-sloping curves
•money supply M1A M1B
•money market equilibrium where demand and supply intersect (points E and F).
•the interest parity condition holds
• Infinitely many combinations will satisfy the
equilibrium conditions
• Each of these combinations will produce one
level of the interest rate and one of the money
stocks
• The fixed exchange rate arrangement is
compatible with any possible level of the
interest rates and of the money stocks
• There is a fundamental indeterminacy in this
system
How can the indeterminacy
be solved?
• Two possible solutions:
– The asymmetric (hegemonic) solution
• One country to take a leadership role by anchoring the
money stock for the entire system
• Example: Country A is leader and chooses point G; then
country B has to take point H
– The symmetric (co-operative) solution
• Countries decide jointly about the level of their money
stocks and interest rates
• The mechanics of interventions in the foreign
exchange market are different in the
symmetric and asymmetric system
• We illustrate this when a speculative crisis
erupts
Intervention in a
symmetric system
Country B
Country A
rA
rB
r3
r’2
•Currency B is expected to
devalue
•Speculators sell currency B
against currency A
•Central bank B buys its own
currency and sells currency
A
•Country B’s money stock
declines and country A’s
money stock increases
r1
r2
M3B
M1A M2A
MA
M2B
M1B
M
B
Asymmetric intervention
• Country B does all the adjustment
– Money stock declines to M3B
– Interest rate increases to r3
• Country A keeps money stock and interest
rate unchanged (using sterilization policies)
• The Bretton-Woods system and the EMS
were asymmetric
– When a speculative crisis arose, the leadingcurrency country (the US in the Bretton Woods
system, Germany in the EMS) was generally
unwilling to allow its money stock to increase and
its interest rate to decline
Symmetric and asymmetric systems
compared
• Advantages of the asymmetric system
– Discipline on the peripheral country
• Disadvantages of the asymmetric system
– The business cycles in the peripheral country are
likely to be made more intense by the pro-cyclical
movements of the money stock of the periphery
Disadvantage of asymmetric system:
recession in periphery
Centre country
Peripheral Country
rA
r1
M1A
MA
M1B
MB
Money demand in periphery declines; since centre country keeps interest rate
fixed, money supply in periphery must decline; monetary policy is pro-cyclical,
aggravating the recession; total money stock in system declines
A recession in the peripheral country
in a symmetric system
rA
Centre country
M1A
M2A
rB
MA
Peripheral
country
M2B
M1B
MB
In this system central banks cooperate; peripheral country reduces its
money stock while centre country increases it; total money stock in
system is unchanged
Conclusion
• Incomplete monetary unions often lack
credibility and are often hit by a speculative
crisis
• Increasing capital mobility increases the fragility
of fixed exchange rate regimes
• This has put many countries in the
uncomfortable dilemma that they have to
choose between either more exchange rate
flexibility or a monetary union
• Fixing exchange rates in Europe can only work
as a transitory device towards full monetary
union