EU int

• The Werner Report


  Transition to economic and monetary unification in 3 stages over 10 years

  Stage 1 : limitation of bilateral exchange rate fluctuations and coordination of monetary and fiscal policies-

  Stage 2 : narrower margins of fluctuations and nominal convergence

  Stage 3 : exchange rates irrevocably fixed (single currency not ruled out) and capital controls definitely removed. • Proposed the establishment of a European System of Central Banks responsible for monetary policy (with no operative details)

  • Coordination of national fiscal policies should be implemented under a not specified "center of decision for economic policy"
• Monetary Snake


  The system was managed by a board of European central banks' governors.

  • European currencies were pegged to the Dollar with a fluctuation band ± 2.25% (the "tunnel" ) [abandoned in March 1973: since then, they were freely floating vis-à-vis the US Dollar]

  • At the same time European currencies were pegged to each other with a fluctuation band ±2.25% (the "snake")

  • Informally, participating central banks were committed to intervene in foreign exchange markets in a coordinated way to stabilize their bilateral parities relative to the DM as an implicit "anchor" on the regional monetary system.

  • If the peg proved unsustainable, the board of central banks' governors could authorize a "realignment" vis-à-vis the DM.
• Short- and Very-Short Term Financial Facilities

  -Designed as a mechanism through which central banks of "strong currencies" (i.e. the German Bundesbank) would lend to central banks of "weak currencies" in order to help them intervene in the foreign exchange market-West Germany successfully insisted on limiting the magnitude of these facilities to a minimum.
• Sacrifice Ratio


  governments should ride the Phillips Curve in the opposite direction. additional unemployment caused by a 1% fall in inflation
• Why the Snake failed (3 reasons)

  1. Oil shock- The continuous appreciation of DM relative to a "weak" Dollar had negative consequences for exports of the rest of European countries and worsened the recession caused by the oil shock

  2. No coordination- There was no mechanism to coordinate monetary and fiscal policies of the two groups of countries. The rest of European countries had no influence on the determination of monetary policy in West Germany

  3. led to political tensions between countries committed to price stability (West Germany and small DM area) and countries with expansionary policies, still trying to trade off inflation and unemployment after the oil shock of 1973
• ECU (European Unit of Account)


  Where EEC budget and CAP transfers were denominated

  - a unit of account based on a basket of European currencies with mutually fixed exchange rates)

  - destabilized by changing parities (as in 1969 with the FF devaluation and DM revaluation)
• monetarist interpretation of stagflation

  Stagflation was caused by high inflationary expectations of workers and employers: →wage indexation transmitted automatically price increase to wage increase; unions anticipated higher inflation in the future and pushed wages even further. →unused output potential increased and firms expected low profits in the future → entrepreneurs kept investments low and growth was low • Aggregate demand management was the problem, not the fix • Restrictive monetary policies were necessary to eradicate inflationary expectations: in the long run, inflation rate should fall and unemployment goes back to its natural rate.
• Two-tiered system


  • After the oil shock of 1973, the Snake proved quickly unsustainable for "weak" currencies of countries with rising inflation and widening current account deficit (UK, Ireland, France)

  - In turn, Sweden and Norway joined in the Snake in 1973 → emergence of a small DM-area (Belgium, Netherlands and Scandinavian countries) • In the end, only few EEC countries (Belgium, Netherlands, Denmark) could follow the DM in its continuous appreciation against the Dollar →nominal divergence in Europe.
• Purchasing power parity


  - a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries

  - the external value of a currency adjusts in order to equalize purchasing power across economies
• Inflation differential


  Foreign inflation - domestic inflation= exchange rate appreciation

  - the PPP theory of exchange rates predicts that when this differential is positive the domestic country's nominal exchange rate appreciates and when this differential is negative the nominal exchange rate depreciates
• Fiscal Dominance


  A situation in which monetary policy is systematically defined by fiscal policy
• Real Exchange rate


  relative price of domestic and foreign products

  - an indicator of competitiveness
• Nominal Exchange rate


  the rate at which one country's currency trades for another
• Key consequence of PPP

  • The equilibrium real exchange rate between France and Germany is constant in the long run →any deviation from the equilibrium exchange rate is mean reverting

  - nom exch rate realignments (voluntary or forced like speculative attack) as mechanism that forces PPP to hold in case of prolonged monetary policy (inf) differentials under fixed exchange rates
• Maastricht Criteria


  tough standards on inflation, currency stability, and deficit spending established in the Maastricht Treaty that European nations must meet in order to join EMU

  - nominal convergence required for fixed exchange rate stability
• Balassa-Samuelson Effect


  Countries with high productivity growth also experience high wage growth, which leads to higher real exchange rates.

  -In increase in wages in the tradable goods sector of an emerging economy will also lead to higher wages in the non-tradable (service) sector of the economy. The accompanying increase in inflation makes inflation rates higher in faster growing economies than it is in slow growing, developed economies
• Bretton woods 3 Clauses

  (1) commitment to fixed exchange rate vis-a-vis gold or a currency convertible into gold (USD) with a ±1% fluctuation band.

  (2) escape clause!

  a. in case of temporary current account deficit, governments should finance it by using their reserves and drawing on IMF quotas to keep the exchange rate in line with the official parity

  b. in case of structural imbalance, governments could devalue their currency after reaching and agreement with the IMF

  (3) governments should restore quickly full convertibility of their currencies for current account transactions but could maintain controls on short-term and portfolio financial transactions (to limit speculation and facilitate exchange realignments)
• Impossible trinity: Bretton Woods


  Capital controls (limited financial integration), fixed exchange rate, monetary policy autonomy
• Britain Currency Crisis 1960-67

  - Governments were committed to full employment; to enhance growth, they used fiscal stimulus (i.e. deficit spending) that led to fast money supply growth

  - Devaluation unpopular economically and politically

  - continuous appreciation of the real exchange rate, structural trade deficit, and continuous speculative attacks between 1964 and 1967 →the Bank of England had to borrow heavily from the IMF and the FED to defend the peg to the Dollar

  - When international reserves were almost exhausted, the govt asked for more $ from IMF, who refused

  - speculative attack on the Pound forced 14% devaluation and new international loan.
• The Franco-German monetary crisis of 1969


  External imbalances caused a serious monetary crisis between France and West Germany

  • France: fast increase in nominal wages; consumer price inflation heading to 6% in the late 1960s

  • West Germany: high productivity, wage moderation and low price inflation

  →France structural trade deficit, pressures for depreciation of the FF and continuous decline of international reserves; however, devaluation was unacceptable for De Gaulle's political ambitions →WestGermany: structural trade surplus and pressures for appreciation of the DM • 1968-69: waves of protest and strikes, political crisis in France → sudden capital flight from FF to DM

  - The French government pressed hard on West Germany for a parallel FF devaluation/DM revaluation

  - W Germ accepted (reluctantly) by De Gaulle's resignation: FF devalued by 11%, DM appreciated by 9% in

  - Devaluation in France was followed by a austerity measures to bring price inflation under control, got $ from IMF
• The N-1 Problem


  In a system of N currencies (including the US$), there are only N-1 nominal exchange rates to the «anchor» currency (the US$) →under «Trilemma», when currencies are pegged to the US$ and capital mobility is unconstrained, the N-1 countries have to run a monetary policy that is consistent with the peg • Interest rates have to converge to the same rate, but the «anchor» country has the privilege to set its monetary policy independently of the peg constraint

  → Therefore, US economic policy determined the interest rate for the whole Bretton Woods system. • The degree of freedom in the system can be used to pursue some joint objective (e.g. stabilizing employment or prices). However, in case of diverging objectives, it can turn into a source of conflicts between member countries.
• "De facto Dollar Standard"


  Gold convertibility of the USD was in theory an instrument other countries could use to impose discipline on the USA: gold was a constraint for US monetary policy, as 25% of the US monetary base had to be backed by gold reserves

  • If USD was expected to be devaluated, other central banks could ask the US to convert part of their dollar reserves into gold (virtually the only international reserve held by the USA) and US money supply would fall

  • Only happened on small scale (e.g. Gaullist France hostile to US «exorbitant privilege»): dollar liquidity was necessary to international trade and US capital exports and official aids were economically and politically fundamental for key countries- e.g. West Germany
• The Dollar confidence crisis

  - Since Vietnam, US expansionary fiscal and monetary policy-> increased inflation

  - US account surplus turned deficit by late 60s

  - dollar was main intl currency, expansion of stock of $s held by foreign central banks as reserves implied declining ratio between gold and US foreign Monetary liabilities (Triffin dilemma)

  - rest of world began to worry abt us govt ability to keep its gold to dollar commitment

  - expectations of $ devaluation led to gold conversion and capital flight from dollar to other currencies
• Triffin Dilemma


  The potential conflict in objectives that may arise between domestic monetary and currency policy objectives and external or international policy objectives when a country's currency is used as a reserve currency
• Collapse of Bretton woods


  - USA become deficit country w weak currency, west germany blamed US for not accepting responsibilities as anchor, wanted them to stop expoting inflation

  - massive capital flight from $ to Dimark

  - bundesbank stopped intervening in foreign ex mkt and allowed dimark to float and appreciate (recovered its monetary autonomy)

  - Nixon Admin suspend convertibility of dollar into gold

  Smithsonian agreement- 8% devaluation of the Dollar (from US$35 to 32 per ounce of gold) and DM revaluation; larger fluctuation bands (±2.25%) → failure; generalized transition to floating exchange rates in 1972-73.
• Smithsonian Agreement


  Nixon Admin ends convertibility of dollar to gold

  8% devaluation of the Dollar (from US$35 to 32 per ounce of gold) and DM revaluation; larger fluctuation bands (±2.25%) → failure; generalized transition to floating exchange rates in 1972-73.
• European Monetary System


  1. Managed by committe of central bank governers

  2. based on exchange rate mechanism 1 (EU currencies linked to eachother, narrow fluctuation band of 2.5%- but high inf countries could have 6%)

  3. Adjustable pegs in case of persistent inf gap

  4. capital controls permitted for high inf countries

  5. no anchor currency, but de facto anchored to DM
• Soft EMS


  a return to bretton woods!

  Capital controls temporarily, fixed ex rate (w/ adjustable peg realignments), autonomous MP
• Hard EMS


  Free flow of capital, fixed ex. rate (no realignments!), cooperative MP
• Was EMS based on cooperation or discipline?+ end of EMS


  - more discipline than cooperation!

  - w germany kicking other countries into shape

  - very rigid, countries prone to speculative attacks bc of free flow of capital

  - triffin dillemma of Germany only thinking of themselves and not other EMS countries, led them to look to monetary integration (single currency) for final solution
• French Crisis 1981-83


  - 1979-80 oil shock, socialist govt elected (big mistake)

  - responded with fiscal and monetary stimulus noooo

  - increased min wage, reduced hours worked, nationalized coal and steel cos and banks

  - led to 12% rise in inflation

  - eventually, '83 austerity policy and DM+franc realignment
• "Market fragmentation"- issues pre EMU

  - thousands of frictional barriers reduce intra eu trade and competition

  - EU firms dominate natl/domestic mkts, but marginal in rest of Europe. high prices and high # of firms
• Advantages of supply side policies (lecture 10)

  - Non-inflationary:-enhanced competition reduces mark-ups

  -innovation increases productivity and reduces costs

  →thus leading to lower prices
• Effects of Single Mkt prog 1992

  preparing for increased competition, waves of merges & acquisitions ("merger mania") since 1986

  →restructuration of the European industry: larger and more efficient firms (although at a cost of significant job destruction) →scale economies

  - higher concentration at EU level, price-cost margins fall
• Effects of trade liberalization

  1) Liberalization ("defragmentation") increases competition in each market

  →mark-up falls, however market size increases for each firm →at each level of mark-up, a higher number of firms can now survive (sale volume per firm increases)

  2) firms suffer losses →process of industrial restructuring (bankruptcies, M&A)

  • In the new equilibrium, surviving firms can increase sales volume and markup, and decrease their average cost →economies of scale leading to efficiency gains

  • Consumers obtain a welfare gain
• EFTA


  European Free Trade Association
• EEA (European Economic Area)


  extension of single market access and rules to EFTA countries, with the exception of CAP and common external tariff

  -EEA countries committed to accept EEC single market legislation (directives, regulations) →Essentially EEA countries accepted to implement in their legislation all decisions related to the single market made at supra national level, in which they had no right to participate.

  (better off being an EU member!!)
• CAP


  Common agricultural policy
• association agreements/"Europe Agreements"


  - Level playing field in trade with post communist eastern european countries

  - eliminating tariffs and quantitative restrictions on industrial exports

  -however, restrictions maintained on "sensitive" products of declining industrial sectors (textiles, coal, iron and steel, chemical) and agricultural products

  - led to fast growth of trade

  • Completely free access to the Single Market required accession of CEECs to the EU →new round of "domino effects" leading to enlargements of the EU

  • The ground for accession was prepared by the adoption by CEECs of EU laws, rules, norms and practices in the process of transition to a market economy

  →enhanced institutional convergence.
• Copenhagen Criteria (2 categories)

  1. Political : stable institutions, democracy, rule of law, human rights, protection of minorities

  2. Economic: market economy (e.g. price liberalization, privatizations), capacity to meet competitive pressures from UE and to commit to the obligations stemming from entry, including entry into the EMU (e.g. macroeconomic stability).