Exchange%20Rate%20Regimes%20and%20the%20Euro

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Exchange Rate Regimes and the Euro

• MBA W7
• Professor Dermot McAleese

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EXCHANGE RATE AND BUSINESS

• Business is affected by
• ? The level of exchange rate
• ? The exchange rate regime
• ? The methods of defending the regime
• ? Currency instability

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OUTLINE

• ? The global exchange rate system
• ? Floating exchange rate in theory and practice
• ? Search for stability
• ? EMU and the introduction of euro
• ? Conclusions

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EXCHANGE RATE ARRANGEMENTS
End-1984 148 countries
Source IMF International Financial Statistics
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EXCHANGE RATE ARRANGEMENTS

End - 1999 184 countries
Source IMF International Financial Statistics
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FEATURES OF THE PRESENT GLOBAL EXCHANGE RATE SYSEM

• ? The words 3 major currencies, the US, the yen
  and the euro are independently floating
• ? A growing number of countries have adopted a
  flexible exchange rate regime
• ? Yet 38 of currencies still linked at a fixed
  rate (pegged) to another currency or basket of
  currencies and 14 more are managed float
• ? Although countries with pegged currencies are
  numerous, their combined economic weight in world
  trade is modest
• ?Movement towards more extreme exchange rate
  regimes

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• There are no major difficulties to prevent the
  prompt establishment by countries of a system of
  exchange rates freely determined in open markets,
  primarily by private transactions, and the
  simultaneous abandonment of direct controls over
  exchange transactions. A move in this direction
  is the fundamental prerequisite for the economic
  integration of the free world through
  multilateral trade.
• Milton Friedman, 1956

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CHANGES IN THE EXCHANGE RATE AND PAYMENTS
IMBALANCES
Exchange rate (domestic currency per unit of
foreign currency)
D1
S0
D0
E
E0
D1
D0
Q0
Q1
Q
Amount of Foreign Exchange
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EXCHANGE RATE DETERMINANTS

? Supply of forex ? Demand for forex ?
Equilibrium exchange rate ? Direct and indirect
effects of ?ER ? Balance of payment
deficit/surplus ? Changes in ER over time
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FLOATING EXCHANGE RATE

• ? Advantages
• ?Increased autonomy in monetary policy
• ?Low foreign reserves requirements
• ?No more balance of payment and ER crises
• ? Disadvantages
• ?Volatility inhibits trade and investment
• ?Destabilising speculation exacerbates the
  problem
• ?Domestic stabilisation measures can be
  undermined

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SEARCH FOR STABILITY

• Two ways to obtain stability
• Pegging to an anchor currency (Ecuador, Baltic
  States, Hong Kong, French West Africa)
• A single currency (the euro)
• (Because of time constraints we focus on the
  euro.)

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A SINGLE CURRENCY

THEORY OF OPTIMUM CURRENCY AREAS STRESSES ?
Labour mobility ? Wage and price flexibility ?
Counter-cyclical fiscal transfers ? Trade and
investment links ? Proneness to asymmetric
shocks ? Credibility of link
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LEAD INDICATORS OF EXCHANGE RATE CRISES

• ? Overheating
• ? Inflation
• ? Current account deficit
• ? Domestic credit expansion
• ? Asset prices
•  

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MEASURES TO INFLUENCE THE EXCHANGE RATE

• (1) Direct intervention in the forex market
• (2) The interest rate
• (3) Throwing sand in the wheels of the forex
  market
• (4) Enhanced international co-ordination of
  economic policy
• (5) Ministerial and government statements

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EUROPEAN MONETARY UNION

• ? Efficiency gains
• ?Transaction costs
• ?Exchange rate uncertainty
• ?Transparency of prices
• ?Enhanced role of EU in the international
  monetary system
• ? Costs
• ?Incidence of asymmetric shocks
• - difference in production structure of
  economy
• - extent of trade and investment
• - degree of factor mobility
• - wages and prices flexibility
• - degree of fiscal integration
• ?Transition costs

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• ? On-going debate
• ?Inappropriate monetary policy one size fits
  all
• ?Enlargement of membership
• ?Stability and Growth Pact (too restrictive
  fiscal targets)

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BACKGROUND TO EMU

• ? 1970 Werner Report
• ? 1979 European Monetary System
• ? 1989 Delors Report
• ? 1991 Maastricht Treaty
• ? 1996 Stability and Growth Pact
• ? 1998 European Central Bank
• ? 1999 Single currency
• ? 2002 Euro in circulation

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FINAL COMMENTSEXAMSDE-BRIEFING