CHAPTER

20 International Economics

Flexible versus Fixed Exchange Rates,

EMS, and Macroeconomic Policy
Coordination
LEARNING GOALS
After studying this chapter, you should be able to:
◼ Identify the advantages and disadvantages of fixed and flexible exchange
rates
◼ Understand the meaning of an optimum currency area
◼ Describe the creation of the euro and the operation of the European Central
Bank
◼ Describe the operation of a currency board and how it works in the nations
that adopted it
◼ Describe adjustable pegs, crawling pegs, managed floating, and how they
work
◼ Know the meaning and importance of macroeconomic policy coordination
 Introduction
◼ There is no clear-cut conclusion about whether fixed or flexible
exchange rates are superior
◼ Advocates of a fixed exchange rate system argue for the certainty
and stability of fixed exchange rates
◼ Advocates of a flexible rate claim more efficiency in correcting BOP
disequilibria
◼ Within a nation, there are clearly benefits to a single currency
◼ What is the optimum currency area, or how large can the area be
before the costs of a single currency outweigh the benefits?
◼ Whether flexible or fixed exchange rates are better depending on
the nation or region involved and the conditions under which it
operates.
The case of Flexible Exchange Rates
◼ A flexible exchange rate system is more efficient than a
fixed exchange rate system because:
◼ It relies only on changing exchange rates, not prices, to
adjust the BOP
◼ It makes adjustment smooth and continuous rather than
occasional and large. This results in stabilizing speculation,
which dampens fluctuations in exchange rates.
◼ It clearly identifies the nation’s degree of comparative
advantage and disadvantage in various commodities when
these equilibrium exchange rates are translated into
domestic prices.
Flexible Exchange Rates

◼ The policy advantage of a flexible exchange rate

system
◼…
◼ The policy disadvantage of a flexible exchange
rate system
◼ ….
The case of fixed Exchange Rates
◼ The case for fixed exchange rates rests on:
◼ Less uncertainty than flexible exchange
rates, especially in the short run
FIGURE 20-1: Shift in the Nation’s Demand Curve for Foreign
exchange and Uncertainty
The case of fixed Exchange Rates
◼ The case for fixed exchange rates rests on:
◼ Stabilizing Speculation
The case of fixed Exchange Rates
◼ The case for fixed exchange rates rests on:
◼ Price Discipline
The case of Fixed Exchange Rates

◼ The case for fixed exchange rates rests on:

◼ The Open-Economy Trilemma
◼ A fixed exchange rate, unrestricted capital flows, and
monetary independence cannot all be achieved at the
same time
Fixed Exchange Rates
The case of Fixed Exchange Rates

◼ The case for fixed exchange rates rests on:

◼ The Open-Economy Trilemma
◼ A fixed exchange rate and unrestricted capital flows can
only occur if a nation gives up monetary policy autonomy
◼ A fixed exchange rate and monetary autonomy can be
achieved only if capital flows are restricted
◼ Monetary policy autonomy and unrestricted capital flows
can be achieved only if exchange rates are not fixed
Optimum Currency Areas, The EMS, and EMU
◼ An Optimum Currency area of bloc refers to a group
of nations whose national currencies are tied by
permanently fixed exchange rates
◼ The currencies of member nations could then float
jointly with respect to the currencies of nonmember
nations.
◼ Regions of the same nation, sharing as they do the
same currency, are optimum currency areas.
Optimum Currency Areas, The EMS, and EMU
◼ Conditions that make optimum currency area
optimum:
◼ The greater mobility of resources among member
nations
◼ The greater their structural similarities
◼ The more willing they are to closely coordinate their
fiscal, monetary, and other policies.
Optimum Currency Areas, The EMS, and EMU
◼ Benefits of optimum currency area
◼…
◼…
◼ Disadvantages of optimum currency area
◼ …
◼ …
Optimum Currency Areas, The EMS, and EMU
The EMS:
◼ Formed in March 1979, laid the foundations for
the later monetary union of the members of the
EC
◼ Objectives:
◼ Greater stability in exchange rates among EMS currencies
◼ Greater convergence among the economies of participating

countries
Optimum Currency Areas, The EMS, and EMU
The EMS:
◼ Main features:
◼ Established the European Currency Unit (ECU), defined
as the weighted average of member currencies
◼ Established narrow bounds for fluctuation (+-2.25%)

around parity, establishing a fixed exchange rate system

but an adjustable exchange rate system.
◼ Established the European Monetary Cooperation Fund

to provide short–term BOP assistance to its members.

Optimum Currency Areas, The EMS, and EMU

1979-1992: there was a total of 11 currency

realignments of the EMS
◼ High-inflation countries had to devaluate to maintain
competitiveness with low-inflation countries
◼ Difficult to keep exchange rates within the defined bands

without being able to align monetary, fiscal, and tax

policies
◼ High-inflation countries were better able to restrain

inflation, but the cost was higher unemployment

Optimum Currency Areas, The EMS, and EMU
The Maastricht Treaty (Dec.1991), generated the agenda
by which full monetary union would be achieved.
◼ Stages for EMU:
◼ Stage 1 (from 1 July to 31 Dec. 1993): Coordination of
macroeconomic policies and removal of barriers to capital
movements within nations
◼ Stage 2 (from 1 Jan. 1994-31 Dec.1998): Establishment of the

European Monetary Institute as a forerunner to the ECB

◼ Stage 3 (started on 1 Jan.1999): Introduction of the euro as the

single currency of the Member States, and the implementation of

a common monetary policy.
Optimum Currency Areas, The EMS, and EMU
◼ EMU- Objectives:
◼ Support sustainable economic growth and a high level of
employment through appropriate economic and monetary
policymaking. This comprises three main fields:
◼ Implementing a monetary policy that pursues the main objective of
price stability;
◼ Avoiding possible negative spillover effects due to unsustainable
government finance, preventing the emergence of macroeconomic
imbalances within the Member States, and allowing the Member
States to coordinate their economic policies among themselves to a
certain degree;
◼ Ensuring the smooth operation of the internal market.
Optimum Currency Areas, The EMS, and EMU
Conditions for joining the EMU (5):
◼ Price stability:
◼ The inflation rate no higher than 1.5 percent greater than
the average of three members with the lowest rates
◼ Sound and sustainable public finances:
◼ A budget deficit no greater than 3 percent of GDP
◼ Overall government debt no greater than 60 percent of
GDP
Optimum Currency Areas, The EMS, and EMU
Conditions for joining the EMU (5):
◼ Long-term interest rates not to exceed 2 points more
than the average interest rates of the three countries
with the lowest rates
◼ Exchange rate stability
◼ The average exchange rate not falling by more than 2.25
percent of the average of the EMS for the two years prior to
joining.
Optimum Currency Areas, The EMS, and EMU
1999: the EMS became the economic and monetary
union (EMU), a more extensive system of coordinated
economic and monetary policies
◼ The euro became the common currency of 20 countries
◼ Member countries: Austria, Germany, Belgium,
Bulgaria, Croatia,…
◼ Function of EMU:
◼ To enhance Europe’s power in international affairs
◼ To make Europe a unified market
◼ To make Europe politically stable and peaceful
Optimum Currency Areas, The EMS, and EMU
Optimum Currency Areas, The EMS, and EMU
TABLE 20.3: Official Currency Conversion Rates for the Euro
Optimum Currency Areas, The EMS, and EMU
The ECB and the Common Monetary Policy
◼ The ECB is the operating arm of the European System
of Central Banks
◼ The main task is to deliver price stability
◼ Independent of the European Parliament

◼ Strategy:
◼ Two elements: Quantitative or Price stability objectives,
and two pillar assessment of risk to price stability.
Currency Boards Arrangements (CBA) and
Dollarization
◼ Under a CBA, a nation rigidly fixes the exchange rate of
its currency to a foreign currency, SDR, or composite, and
its central bank ceases to operate as such.
◼ CBA are similar to the gold standard in that they require
100 percent international-reserve backing of the nation’s
money supply.
◼ With a CBA, the nation’s money supply increases or
decreases, respectively, only in response to a BOP surplus
and inflow of international reserves or to a BOP deficit
and outflow of international reserves.
Currency Boards Arrangements (CBA) and
Dollarization
◼ A currency board is the most extreme form of exchange
rate peg short of adopting a common currency
◼ Usually done when the nation is in a deep financial crisis
and to combat inflation
◼ Advantages of CBAs
◼ Disadvantages of CBAs
Currency Boards Arrangements (CBA) and
Dollarization
◼ Dollarization is the adoption of another nation’s
currency as legal tender.
◼ Benefits of dollarization
◼…
◼ ….

◼ Costs of dollarization
◼ ….
◼ …..
Exchange Rate Bands, Adjustable Pegs,
Crawling Pegs, and Managed Floating
◼ Exchange Rate Bands
◼ Most fixed exchange rate systems allow the exchange rate
to fluctuate within narrowly defined bands above and
below par value.
◼ The nation decides on the exchange rate, or par value, of their
currencies.
◼ The actual exchange rate under a fixed exchange rate
system is determined by supply and demand forces
within the band of fluctuation and is prevented from
moving outside the band by official intervention in
foreign exchange markets.
Exchange Rate Bands, Adjustable Pegs,
Crawling Pegs, and Managed Floating
◼ Adjustable Pegs Systems
◼ An adjustable peg system requires defining the par
value and the band of fluctuation, with the
stipulation that the currency will be devalued to
correct BOP deficit, or revalued to correct BOP
surpluses.
◼ The Bretton Woods system was originally set up as
an adjustable peg system.
Exchange Rate Bands, Adjustable Pegs,
Crawling Pegs, and Managed Floating
◼ Crawling Pegs
◼ Under a crawling peg system, par values are changed by
small preannounced amounts or percentages at frequent
and clearly specified intervals until the equilibrium
exchange rate is reached
◼ This is done to avoid relatively large changes in par
values and possibly destabilizing speculation
◼ See FIGURE 20.5. Exchange Rate Band, Adjustable Pegs,
and Crawling Pegs.
 Exchange Rate Bands, Adjustable Pegs,
Crawling Pegs, and Managed Floating
◼ Managed Floating
◼ Under this system, the nation’s monetary authorities are
responsible for intervening in foreign exchange markets to
smooth out short-run fluctuations without attempting to affect
long-run trends in exchange rates
◼ A policy of leading against the wind requires the monetary
authority to
◼ Supply a portion of short-run excess demand for foreign exchange,
moderating tendency of currency to depreciate
◼ Absorb a portion of any short-run excess supply, moderating

tendency of currency to appreciate.

International Macroeconomic Policy
Coordination
◼ Given the interdependence of nations,
macroeconomic policies are more effective if
coordinated.

◼ International macroeconomic policy

coordination thus refers to the modifications of
national economic policies in recognition of
international interdependence.
International Macroeconomic Policy
Coordination
◼International cooperation has proven
difficult because of:
◼ Lack of consensus about the functioning of
international monetary system
◼ Disagreement on how to distribute gains from
successful policy coordination among participants
◼ Disagreement on how to spread cost of negotiating
and policy agreement
◼ …
Chapter 20

Q&A