Optimal Currency Area - EMS (L10)

Question 1

What determines Nominal ER?

Answer 1

FOREX MARKET, throguh forces of supply and demand

Question 2

Factors influencing ER

Answer 2

1. Inflation
2. Budget deficits
3. investment

Question 3

How to calculate REAL exchange rate?

Answer 3

Nominal ER * relative prices

Question 4

Formula for E(r) Real exchange rate?

Answer 4

E(R) = E(n) * (P/P*)

E(n) = nominal exchange rate
P = domestic price for a bundle of products
P* = foreign price for the same bundle of goods

Question 5

Why does real ER matter?

Answer 5

Matters for the welfare of the importer, imagine being a tourist and if the Real ER of your currency depreciates against the foreign currency, everything will be more expensive

Question 6

What is the law of one price?

Answer 6

Real ER everywhere converges to 1.

Market should eliminate price differences through trade in the long run - nominal ER should exactly balance price ratio.

e.g., in the case of a cheeseburger the real exchange rate of the burger is 0.5 : 1. this is because price in UK is 1 LB but $3 in the US which is equivalent to 2£, so the cheeseburger is more expensive in the US.
so under free trade UK exporters have an incentive to export the cheeseburger to the US which will reduce the burger price in the US until the real ER equals to 1.

Question 7

how do you restore competitiveness to a country with a high real ER?

Answer 7

1. deflation
2. devaluation

Question 8

how does deflation restore competitiveness?

Answer 8

reduces home prices by cutting back on demand and lowering costs

BUT often leads to higher unemployment as price goes down, supply goes down and domestic firms find it harder to sell.

Question 9

how does devaluation restore competitiveness?

Answer 9

purposefully devaluating your currency (by interest rates etc.) to make imports cheaper and more competitive

Question 10

can countries with a shared currency use both these methods?

Answer 10

NO. Countries that share a currency cannot use devaluation, as there is no such thing as E(n).
Issues for eurozone currencies

Question 11

What is the main problem of fluctuating of exchange rates?

Answer 11

1. ER may tend to overshoot (Can fluctuate more than the normal range due to speculations causing it to go up an excessive amount) and can have a destabilising effect.
   Traders want a stable price so not a good environment for trade.
2. Due to fluctuations.. Government is tempted to stabilise the exchange rate, e.g., Bretton woods system of pegging ER post WW2.

Question 12

what is the impossible trio?

Answer 12

3 objectives which are ideal for government to pursue

1. Stabilise nominal ER (good for traders)
2. Free trade and investment flows (more specialisation)
3. Independent monetary policy (better tuned to local conditions)

Question 13

what are the combinations of the possible trio?

Answer 13

If a country chooses free capital movement and a stable exchange rate, it must give up independent monetary policy. This is because capital flows may put pressure on the exchange rate, and the central bank may have to adjust interest rates to maintain the desired exchange rate.

If a country chooses independent monetary policy and free capital movement, it cannot have a stable exchange rate. Capital flows can cause fluctuations in the exchange rate, and the central bank may need to adjust interest rates to stabilize the currency.

If a country chooses independent monetary policy and a stable exchange rate, it must impose capital controls to restrict the free movement of capital. This is because unfettered capital flows could undermine efforts to maintain a fixed exchange rate.

Question 14

In the EU, given there is free trade, you can only have which 2 of the 3 trilemma

Answer 14

1. Fixed ER or 3. Independent monetary policy

Question 15

how does the impossible trio take place in real life?

Answer 15

The collapse of the Exchange rate Mechanism: several European countries agreed to commit to maintain their nominal ER in a narrow band against each other.
They agreed to peg their interest rate to German currency (if German currency appreciates, all our currencies appreciate). It was strong in the 70s.

They chose 1. Stable nominal ER (as they were already in the EU) and abandon independent monetary policy, they must follow Germany’s monetary policy as they must follow Germany’s interest rates.

But in 1992/3 German re-unification boom caused inflation to rise in G and German interest rate was increased.
So other countries in the ERM, they couldn’t follow Germany’s interest rates because they would lower their growth through lower investment and demand.

BUT If you do not follow Germany, then according to impossible trio, you cannot have a fixed exchange rate.

Instead, they either had to:
a) Raise interest rates to match
b) Allow their nominal ER to fall

They tried to raise their interest rates to match but it worsened the recession as home (credit became more expensive)

Markets bet money that governments would choose (b) leading to a collapse in the ERM.

Question 16

BENEFITS of a common currency?

Answer 16

1. elimination of transaction costs - banks used to charge comission fee when changing currency
2. greater price transparency leads to competition - before you didn’t know which seller to buy from, Spanish or German due to exchange rates, but now you can know.
3. removes exchange rate uncertainty + price mech. Without monetary union, it’s possible for exchange rate to overshoot which leads to uncertainty from buyers and sellers

Question 17

Problems of a common currency?

Answer 17

1. Loss of exchange rate as an adjustment mechanism

Suppose you are not in an MU, if your C.O.P goes up and competitiveness goes down, one way of restoring competitiveness is to devaluate your currency to sell it at a lower price. But in a monetary union, if an area loses competitiveness, it can only regain it by deflation/ lower price rises, over long period -> high unemployment + slow growth

Critics of monetary union (MU) conclude that the economic benefits are small and the costs potentially large

Question 18

what is an OCA?

Answer 18

An optimum currency area is a group of countries that are well-suited to share the same currency because their economies are similar and work well together.

Question 19

What are the criteria for countries to share a common currency without seriously adverse effects?

Answer 19

Mundell: Labour market flexibility

Robert Mundell, often called the “Father of the Euro,” argued that for countries to successfully share a common currency, like in the Eurozone, their labor markets must be flexible. This means that if one country faces economic challenges, such as high prices, while another faces low prices, they can’t use individual currency adjustments. Instead, they must rely on their workforce being adaptable. In a monetary union, countries give up the ability to adjust their exchange rates independently. So, if there’s an issue, like one country experiencing inflation and another deflation, workers may need to accept different wages or find new job opportunities to adapt to the changes without relying on currency adjustments.

Question 20

In a MU, what are the automatic mechanisms for restoring equilibrium?

Answer 20

Wage Flexibility: If one country, say France, becomes less competitive due to higher production costs, flexible wages could automatically adjust. Wages might go down in France and up in another country like Germany, restoring competitiveness and balance.

Mobility of Labor: Workers can move easily between countries in the union. This means that if one country faces economic challenges, workers can move to where there are better opportunities without needing wage adjustments. This mobility helps keep things balanced in the union.

Question 21

when is monetary union between two countries optimal? Mudell

Answer 21

Monetary union between two countries is optimal if there is sufficient wage flexibility &/or there is sufficient mobility of labour

Question 22

Is the Eurozone an optimum currency area?

Answer 22

No, but subset of EU countries which are: Germany, France etc.

Question 23

Could the Eurozone become an OCA?

Answer 23

1. Endogenous argument: Although the countries are not similar right now, when countries join the eurozone area, they become more and more similar so they could become suitable partners over time.
2. Business cycles are becoming more synchronised and fewer asymmetric shocks.