Benefits of Monetary Union
Benefits of Monetary Union
1. Credible monetary policy (i.e. low and stable
inflation)
2. Eliminate competitive devaluations
3. Lower trade costs (i.e. no exchange rate risk/ uncertainty)
Unique Features of the ECB
Unique Features of the ECB
Multinational institution.
One of the world’s few multinational central banks.
Very independent, but decision making complicated by the ECB’s Governing Council, which consists of the central bank governors of the Eurozone national central banks and six members of the ECB’s executive board. A very large group of stakeholders and interests.
Forbidden activities.
The ECB cannot:
Forbidden activities.
The ECB cannot:
§ Directly finance member states’ fiscal deficits or provide bailouts to member governments.
§ Act as a lender of last resort by extending credit to financial institutions in the Eurozone in the event of a banking crisis.
These “forbidden activities” have been challenged repeatedly during the sovereign debt crisis.
(ECB did quantitative easing too late after the financial crisis b/c goes against the “bail out/finance fiscal deficits”
Accountability and independence of ECB
Accountability and independence.
No EU institution has any formal oversight of the ECB, and the ECB does not have to report to any political body. The ECB does not release the minutes of its meetings.
The ECB is arguably the most independent central bank in the world.
Criticism of the ECB
Criticism of the ECB
1. Too focused on price stability at the expense of growth?
This has been a particular point of criticism following the financial crisis, as the ECB refused to cut interest rates to the ZLB and implement QE. The ECB’s recent implementation of QE in the euro area is seen as an acknowledgement that policy was too tight during the crisis.
- Controversy over strict interpretation of the “forbidden activities” rules.
The ECB’s mandate has been stretched during the crisis to include banking regulation and oversight (Banking Union) as well as QE and bailouts for Greece.
Do these new powers and tools threaten the independence and credibility of the ECB? - There is also controversy over the ECB’s lack of accountability.
Many EU bodies suffer a perceived “democratic deficit,” with treaties pursued at the intra- governmental level and no popular ratification or consultation.
Qe
purchasing long term government securities, the Fed was increasing the money supply.
The Fed balance sheet expanded rapidly with QE.
Many people expected the long run price level to rise as a result. This led to increased exchange rate expectations.
Cost of giving up monetary policy independence
can’t orient monetary policy towards the needs of the domestic economy. may result in raising the interest rate during a recession in order to shadow the target country, further depressing local output.
Benefit of fixed exchange rate
reduction in exchange rate risk and uncertainty for investors and exporters/importers, which generally increases capital flows, FDI and trade flows, particularly in emerging markets.
Tying one’s hands and shadowing a credible foreign central bank like the fed will lead to price stability, particularly important if the bank is not independent
maintaining a fixed exchange rate following negative terms of trade shock (foreign exchange intervention)
in response to depreciation of the ruble, the Russian central bank must sell foreign exchange reserves (USD bonds) in the FX market and buy ruble denominated assets (ruble bonds or currency). This will contract the Russian money supply and increase the domestic interest rate in Russia. Continue to sell FX reserves until the exchange rate peg is reached.
In a carry trade, investors will borrow and invest where? Country 1 R= 0%, Country 2 R= 2%
In a carry trade, investors borrow in low-interest rate currencies (a.k.a. “funding currencies”) and invest in high- interest rate currencies (a.k.a. “investment currencies”). In the scenario presented here, the carry trade involves borrowing in yen at 0% interest and investing in dollars at 2% interest.
Why is money demand curve flat when R-0? What does R<0 mean?
The money demand curve will be flat at R=0 because people are unwilling to lend money at negative interest rates. Negative interest rates imply that lenders pay borrowers a positive return for their borrowing. If R<0, investors would rather hold cash, which pays zero interest, than hold bonds, which would pay negative interest.
Raising the fed funds rate will…
increase the interest rate
Illustrate the impact of the expected rise in the U.S. interest rate on the euro area economy at the ZLB using the AA-DD model. What happens to the euro area AA curve? The euro area DD curve? Does euro area output rise, fall, or stay the same?
The increase in exchange rate expectations will
cause the AA curve to shift up, leading to an actual rise (i.e. depreciation) in the exchange rate (recall that 𝐄 = 𝐄𝐞 €/$ €/$
from part b.) The upward shift in AA will also cause output to increase, as net exports will go up because of the depreciated currency. DD does not move.
Fiscal Expansion at ZLB vs. normal times
In both cases, a fiscal policy expansion will shift the DD curve to the right. The difference in the economic outcome relates to the exchange rate impact. In normal times, the AA curve is downward sloping, and as such, the fiscal policy expansion increases output while also appreciating the currency. The currency appreciation “crowds out” some of the increase in aggregate demand brought on by the government spending increase, as net exports are negatively impacted by the exchange rate appreciation. In contrast, at the ZLB the AA curve is flat, and as such, the fiscal policy expansion increases output without appreciating the currency. There is no “crowding out” of net exports at the ZLB. Thus, a fiscal expansion will increase output by a greater amount at the ZLB than in normal times.
Is Euro area an Optimal Currency Union?
- Goods market integration – the euro area does well on this
metric. Goods and service trade between euro area members is quite large (although there are some countries on the periphery for which this is not true). - Business cycle synchronization (or symmetry as we called it in the lecture) – here again the euro area does relatively well, as most of the euro area countries are symmetric – i.e. have synchronous business cycles.
- Labor market integration – this is where the euro area falls far short of the criteria for an optimal currency area. Labor mobility is extremely low within the euro area.
- Fisca lintegration–again,the euro area falls far short of the criteria of an optimal currency area due to its lack of a federal fiscal authority that has taxation and spending power, can issue federal bonds, and the lack of automatic stabilizers lack pan-euro area unemployment insurance, etc.
Should Greece have joined the euro area?
Answer: According the 4 OCA criteria, Greece should probably have remained outside of the euro area. It fails all four OCA criteria.
1. Market integration – Greece has very low market
integration with the rest of the euro area. Most of its’ goods exports flow to countries outside of the euro area. Its main export to the euro area is tourism.
2. Symmetry – business cycle synchronization between Greece and the rest of the Eurozone is quite low and may even be negative. That is, the correlation of Greek real GDP growth with the Eurozone is close to zero or even slightly negative.
3. Labor mobility – is low between most Eurozone countries, including Greece.
4. Fiscal integration – is low between most Eurozone countries, including Greece.
What policy proposals would you recommend to improve the feasibility of the euro area as a sound functioning currency union?
Answer: First, try to improve labor mobility through language training grants, lower cross-border barriers to labor integration by setting up pan-euro area standards for certain professions: healthcare, education, skilled trades, law, etc. Second, try to improve fiscal integration through the building up of a euro area transfer scheme or insurance system. Ultimately, this may require deeper political union which does not seem very feasible given the current political environment in the euro area.
Exchange Rate Sterilization
Sterilization refers to a central bank’s efforts to offset changes in the domestic money supply caused by intervention in foreign exchange markets.
How does sterilization work in practice in China (i.e. discuss the various policy measures the People’s Bank of China uses to sterilize its T-Bill purchases)?
Answer: China maintains its exchange rate peg with the USD by purchasing U.S. T-Bills (thereby increasing the supply of Chinese renminbi) and matching its T-Bill purchases with sales of domestic government bonds to domestic banks and/or increases in the reserve requirement for domestic banks. Both of these measures reduce the supply of Chinese renminbi, thereby offsetting or “sterilizing” the initial money supply increase resulting from the T-Bill purchases.
Why are governments interested in sterilizing their foreign exchange interventions?
Answer: Governments may want to sterilize their foreign exchange interventions in order to maintain control over the domestic money supply (and thus maintain control over domestic monetary policy). For example, the reason China sterilizes its T-Bill purchases is to prevent domestic inflation while at the same time maintaining its exchange rate peg with the USD. If a government has a fixed exchange rate and does not sterilize its foreign exchange interventions, the exchange rate peg will prevent the central bank from exercising complete control over domestic monetary conditions.
Do you think the quantitative easing (QE) policy of the Fed helped to raise the expected exchange rate as described in part f above? Why or why not?
Answer: The Fed’s QE policy consisted largely of purchasing long-term Treasury Bills in order to lower long-term interest rates and flatten the yield curve. The USD began to depreciate against a basket of other currencies in mid-2009 and continued that trend into 2011. QE1 began in late 2008 and continued in various forms (QE2 and QE3) until the Fed meeting in November of 2014. However, it is not clear if the depreciation of the USD was due in part to QE, or rather was caused by foreign investors moving their funds back out of the US following the large flight- to-safety capital flows of 2007-2009.
Do you think other countries (particularly emerging market countries) were happy with the Fed’s QE policies? Why or why not? Think about the impact of QE on the exchange rate, and the implications for the current account and capital flows. As a case study, think about the policy response of Brazil that we discussed in class.
Answer: The Fed’s QE policy consisted largely of purchasing long-term Treasury Bills in order to lower long-term interest rates and flatten the yield curve. But the desired decrease in US interest rates led investors to seek higher yields elsewhere, particularly in emerging market economies that were not stuck at the ZLB like Brazil. As a result money flowed out of the US and into Brazil, causing the Brazilian real to appreciate against the USD and increasing Brazil’s current account deficit as Brazil’s imports increased and exports fell. To counteract this, the Brazilian government implemented capital controls to slow the appreciation of the real and prevent some capital from flowing into the country.
Real Exchange Rate
q = E * (Pforeign/Phome)
Real exchange Rate, when q > 1..
Q > 1, your currency is undervalued, traders will buy from you and sell where it is overvalued
