Monetary Integration

Question 1

Nominal exchange rates

Answer 1

Refers to the price of one country’s currency in terms of another

Question 2

Real exchange rates

Answer 2

Real ER = nominal ER x relative prices

Question 3

In the Eurozone which type of ER is fixed and which can vary?

Answer 3

The nominal ER is fixed but the real ER can vary

Question 4

In the long run what should happen to ER?

Answer 4

ER should reflect “law of one price” as the market should eliminate price differences through trade. Nominal ER should exactly balance the price ratio, leaving the real ER everywhere at 1

Question 5

How can a country with a high real ER restore competitiveness?

Answer 5

• reduce prices through deflation by cutting demand, lowering costs, often leading to unemployment.
• devaluation of nominal ER, effective in SR but arguable impact in longer term. Counties that share a currency can’t do this

Question 6

Why do some countries peg their ER to other countries?

Answer 6

In the forex market, the exchange rate tends to overshoot which has a destabilising effect. This is undesirable, so pegging to another country helps limit this

Question 7

Example of country with pegged ER?

Answer 7

Hong Kong to US

Question 8

Bretton woods system

Answer 8

A system post ww2 where each currency was maintained +/- 1% of the dollar

Question 9

Why is stabilising ER hard in the medium run?

Answer 9

Because of the impossible trio

Question 10

What is the impossible trio

Answer 10

1. Stable nominal ER
2. Free trade and investment flows
3. Independent monetary policy
   All of these are desirable but not all 3 can be achieved in the medium term

Question 11

Describe the collapse of the exchange rate mechanism (ERM)

Answer 11

• in 1979, a number of EU counties committed to maintaining their nominal ER in a narrow band with Germany being the nominal anchor
• in 1992/3 german re-unification boom caused inflation and subsequently interest rates rose
• other countries had to either raise interest rates to match Germany or allow their nominal ER to fall
• they tried raising interest rates but this worsened the recession at home
• government eventually made curing the recession a priority over maintaining the ER leading to collapse of ERM

Question 12

Benefits of a common currency

Answer 12

1. Elimination of transaction costs
2. Greater price transparency, note product price differences in eurozone still remain quite high
3. Removal of exchange rate uncertainty, encourages production and investment decisions, lower interest rates offered by banks
4. Economic growth, lower interest rates increase investment
5. Gains from seigniorage (difference between value of money and costs of producing it) increased development of financial market

Question 13

Costs of a common currency

Answer 13

1. Loss of exchange rate as an adjustment mechanism. To restore competitiveness, countries must do so through deflation which causes unemployment and reduced GDP

Question 14

Mundell optimum currency area theory

Answer 14

Countries sharing a currency must have labour market flexibility. This will help offset asymmetric shocks without the need for wage adjustments

Question 15

What does EMU stand for?

Answer 15

Economic and Monetary Union

Question 16

What does the EMU involve?

Answer 16

1. Single currency (euro)
2. Institution to determine and administer monetary policy (ECB)
3. Unified monetary policy, single interest rate, joint control of money supply and exchange rate
4. Free movement of capital
5. Coordinated tax policies

Question 17

What criteria must you meet to be eligible for the euro?

Answer 17

1. Inflation must not be more than 1.5% above the average of the best RU countries
2. Long term interest rate must not be more than 2% above the average of best 3
3. Annual budget deficit must be less than 3% of GDP
4. Public debt must not be more than 60% of GNP
5. Must be no devaluation of exchange rate within the ERM for 2 or more years

Question 18

How is the ECB structured?

Answer 18

• there are 6 independent members of executive board
• 19 governors from national central banks
• governing council meet fortnightly in Frankfurt to decide interest rates in the interest of Europe
• executive board implements decisions and set agenda. They must include, French, German and Italian. They are highly independent and not very accountable

Question 19

What are the ECB’s main objectives?

Answer 19

Price stability since this will support growth and employment.
Maintain integrity of financial system

Question 20

How did the ECB’s open market operations work?

Answer 20

• commercial banks obtain liquidity by offering collateral to ECB and paying an interest.
• main refinancing operation- cash for 7 days at fixed interest rate 0.05% since 2014
• with crisis, lending between banks collapsed so now there are special refinancing operations which are long term

Question 21

How well did the ECB perform pre crisis?

Answer 21

+inflation remained controlled
+ECB developed a reputation for competence but also caution
-ECB act slower than the fed
-ECB failed to control the growth of bank credit and price bubbles in houses (de Grauwe)
-‘one size does not fit all’ policies aren’t beneficial to all countries

Question 22

What is the Taylor rule

Answer 22

A formula to find the best interest rate based in key macroeconomic data (e.g in 2002 Taylor rule said interest rate in Germany should be 2.75% and 7.5% in ireland)

Question 23

What happened to competitiveness in the eurozone 1999-2008?

Answer 23

Competitiveness diverged

Question 24

How did the ECB respond to the crisis?

Answer 24

1. Cut interest rates, standing overnight rates negative for deposits, cut banks reserve ratios releasing more collateral
2. Boost banks liquidity
3. Bought weak government bonds
4. Outright Monetary Transactions (OMT) created
5. New European systemic risk board, they monitor banks behaviour

Question 25

How well did the ECB perform post crisis?

Answer 25

+they cut interest rates but were slower than the Fed +they tackled bank liquidity problems -failed to act decisively until OMT 2012 -didn’t use quantitative easing -Eurozone remains a problem area (out out flat, inflation too low, massive unemployment)

Question 26

Arguments for fiscal policy rules in a MU

Answer 26

* if one country borrows a lot from the capital markets, this negatively affects all countries * borrowers might put pressure on ECB to lower interest rates, however post crisis interest rates are always low * concerns over possible national default. The Maastricht treaty included a ‘no bail out clause’ however other countries are likely to help because it would damage the Eurozone financial system

Question 27

Arguments against fiscal policy rules in a MU

Answer 27

* economies differ and monetary policy national control has already been lost so there is a need for national control of fiscal policy * capital markets will attach risk premium to debt burdens counties but the premium will be reduced if markets believe that other governments would bail out the problem country

Question 28

What action has the EU taken to control national budget deficits?

Answer 28

Pre crisis • stability and growth pact agreed 1997 • stability and growth pact mildly reformed 2005 Post crisis •six pack 2011 • medium term budget balance: Fiscal compact 2013 •current budget balance: European semester 2011

Question 29

What does EDP stand for and what is it?

Answer 29

Excessive deficit procedure It is a way of encouraging countries not to run a large deficit If national budget deficit exceeds 3% of GDP and majority of countries agree that this is excessive then the country has 10 months to cut it or they get a fine

Question 30

What happened to the Stability and growth pact post crisis?

Answer 30

All countries raised their expenditure and so the pact effectively became useless because all countries failed the criteria

Question 31

What is the six pack?

Answer 31

The second reform of the stability and growth pact •started in 2011, it can enforce rules and there must be a reverse qualified majority to vote against it •there is extra EDP, if countries with debt of more than 60% of GDP dont reduce by 5% a year, they will be punished •a cap placed on annual growth of public expenditure

Question 32

What is in the European semester?

Answer 32

* from 2011 there is a review of national policies before enacted * structural reforms * budget surveillance * surveillance of macro economic imbalances

Question 33

What is in the fiscal compact?

Answer 33

* budget deficit must not be greater than 0.5% of GDP and there is an automatic sanction (1% allowed if debt is less than 60%) * national debt of more than 60% must be cut by 1/20th of yearly excess

Question 34

What is the European stability mechanism?

Answer 34

* created in 2012, it is based on the IMF model of conditional loans * it is a permanent intergovernmental institution able to lend €500bn, provide loans, purchase government bonds, give credit lines and support for banks. * in exchange for loans there must be significant fiscal consolidation and structural reform

Question 35

What does IISPG stand for?

Answer 35

Italy Ireland Spain Portugal Greece

Question 36

What went wrong for IISPG?

Answer 36

* except for Greece, governments didn’t behave badly in crisis * the problem started earlier with low interest rates and high confidence * one size fits all Eurozone monetary policy was inappropriate- failed to control credit expansion causing increase in private debt

Question 37

Should Greece leave the Eurozone?

Answer 37

* Greece voted against 2 conditional rescue packages which is controversial because they need the money since their banks are insolvent * leaving the Eurozone would allow Greece to restore competitiveness by devaluing the currency, however it wouldn’t solve the problem

Question 38

What is an alternative to the ECB targeting low inflation?

Answer 38

ECB could regret nominal GDP growth •pursue full employment as well as low inflation •allow catch up for period of recession even if inflation rises •help change expectations to higher growth •create more room for expansionary fiscal policy

Question 39

What effect could austerity measures have on the Eurozone

Answer 39

* in 26 cases of public debt greater than 100%, austerity tended to increase debt/GDP ratio (Costas 2012) * government cutbacks can cause large depressing effect since fiscal multiplier is larger than expected (Blanchard and Leigh 2012) * De Grauwe 2011 and others called for softer austerity and action in the bond market

Question 40

What is a viable alternative to austerity measures?

Answer 40

Soros 2012 suggests 1. Establish a European fiscal authority to assume all solvency risk for all government bonds purchased by the ECB 2. EFA to establish debt reduction fund, ECB acquired all gov debt greater than 60% 3. Issue debt reduction bills treated as highest quality collateral He does however admit Germany wouldn’t agree to this until there is a fiscal union police to budget discipline

Question 41

What lessons can we learn from the EMU?

Answer 41

* entry requirements should have more emphasis on real economics * gains from EMU may be modest but of loss of devaluation adjustment mechanism mat be costly especially for bigger countries * do not rely on rapid convergence of behaviour, you need to start with a more homogeneous good * fiscal union or strong fiscal policy coordination is needed to create thrust but central bank must have power to act as a lender at last resort