Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI VI. Economic Intrdpndnc and Choic of Exchang Rat Rgims In th last sction of this lctur, w tak up th issu of choic of xchang rat rgims undr conomic intrdpndnc. W concntrat on th analysis that shows us th possibl bnfit from losing montary policy autonomy, bcaus it provids a nw prspctiv to th constraints rprsntd by th inconsistnt triangl. It also brings to th for th issu of symmtric and asymmtric xchang rat rgims and what maks a fixd xchang rat arrangmnt last. A bnfit from losing montary policy autonomy Economic intrdpndnc and xchang rat rgims was much discussd in th lattr half of th 1980s, in th broadr contxt of intrnational policy co-opration. Using gam thory, floating xchang rats was portrayd as a systm in which montary authoritis did not co-oprat, fixd xchang rats as a systm in which thy did co-oprat (in on form or anothr). On fruit of such analyss was th conomic intrprtation givn to th Europan Montary Systm (EMS), as a way to achiv lowr inflation by abandoning montary policy autonomy. By now w ar familiar with th trad-off facd by montary policymakrs in choosing an xchang rat rgim. W cannot hav stabl xchang rats, autonomous montary policis and fr capital flows at th sam tim, in gnral. Onc capital controls ar rmovd, a country that chooss to stabilis its xchang rat loss montary policy autonomy. Losing montary policy autonomy is undsirabl, bcaus that maks it hardr to stabilis th domstic conomy. Howvr, thr ar tims whn it maks conomic sns to choos to abandon montary policy autonomy. This is whn th autonomous montary policy is not conduciv to domstic stability. Montary policy of mmbrs of th EMS othr than (Wst) Grmany fit this profil, and mmbrs actually xprincd a dclin in inflation rats aftr joining th EMS (although EMS mmbrs wr not th only advancd nations that saw lowr inflation during th sam priod). This was on important conomic rason bhind th EMS, and th Economic and Montary Union (EMU) which vntually followd. Th conomic rasons for th EMS Th EMS cam into bing in 1979, and providd a living xampl of a non-floating xchang rat systm adoptd by advancd nations. Giavazzi, F. and A. Giovannini (Limiting Exchang Rat Flxibility, Th Europan Montary Systm, MIT Prss, 1989)wr th first to xplain in conomic trms why th Europans chos to stablish th EMS. Thy VI-1
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI citd th mutual opnnss of Europan countris and th Common Agricultural Policy (CAP) as th conomic rasons. Th mor countris ar opn towards ach othr, th highr th proportion of thir GDP that is affctd by gyrations in th rlvant xchang rats. And sinc th CAP aimd at qualising agricultural product prics across nations, xchang rat changs wr a hug nuisanc. It mad conomic sns to introduc a systm lik th EMS. To b prcis, Europ s nw xchang rat systm was calld th Exchang Rat Mchanism (ERM) of th EMS. Th initial plan for th EMS was to stablish th Europan Montary Fund (EMF) along with th ERM. Th EMF was supposd to b th prcursor to a Europan cntral bank, but missd th plannd starting dat of March 1981. Only th ERM rmaind. It is for this rason that EMS is oftn usd as a synonym for ERM. Th mmbrship of th ERM changd throughout th yars. Thr wr vn two major currncy criss, in Sptmbr 1992 and August 1993. But in th nd, th ERM ld to th succssful introduction of th singl currncy uro on papr in 1999, by lvn mmbrs of th Europan Union (EU). Ths countris wr Blgium, Grmany, Irland, Spain, Franc, Italy, Luxmbourg, th Nthrlands, Austria, Portugal and Finland. Grc joind in January of 2001. Nots and coins bgan to circulat in 2002. Slovnia joind in January of 2007, Malta and Cyprus joind in January of 2008, Slovakia joind in 2009, Estonia joind in 2011, Latvia joind in 2014 and Lithuania joind in 2015. What rmains today of th ERM is ERM-II, a systm whrby mmbrs maintain thir xchang rats against th uro within a band of maximum 15% abov and blow th cntral rats. At its start in 1999, th Danish kron and Grk drachma wr th only two currncis in ERM-II. Aftr Grc adoptd th uro on 1 January 2001, Dnmark bcam th only participant, until th Estonian kroon, th Lithuanian lita and th Slovnian tolar ntrd on 28 Jun 2004. Th Cyprus pound, Latvian lats and Malts lira ntrd on 2 May 2005, th Slovak koruna on 28 Novmbr 2005. Th Slovnian tolar was in ERM-II until January of 2007 and th Malts lira was in ERM-II until January of 2008. As ERM-II mmbrs bgan to join th uro, th numbr of mmbrs dclind. Slovakia lft ERM-II whn it adoptd th uro on 1 st January 2009, Estonia lft ERM-II whn it adoptd th uro on 1 st January 2011, Latvia lft ERM II whn th country adoptd th uro on 1 January 2014, and Lithuania lft ERM II whn th country adoptd th uro on 1 January 2015. This lavs only on country in ERM II; Dnmark which obsrvs a cntral rat of 7.46038 to th uro with a narrow fluctuation band of ±2.25%. For a brif account on th procss of montary intgration in Europ, s for xampl Kaji ( Th uro, th nlargd EU and Asia, Asia Europ Journal, Vol.2/No.3, pp.399-414, 2004). VI-2
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI Th Canzonri and Hndrson Modl To analys th choic of xchang rat rgims undr mutual conomic intrdpndnc, w nd a two-country modl in which (at last som of th) ndognous variabls dpnd not just on domstic xognous variabls but also forign xognous variabls. Canzonri, M. and D. Hndrson ( Is Sovrign Policymaking Bad? Carngi-Rochstr Confrnc Sris on Public Policy No.28, pp.93-140, 1988 and Montary Policy in Intrdpndnt Economis, MIT Prss, 1991) usd such modls to analys, among othr things, th conomic gains from joining th ERM. Spcifically, in Sction IV of Canzonri and Hndrson (1988), thy show how a country with a high inflationary bias (Italy) could s its inflation rat dclin by joining th ERM. Th authors thmslvs stat that this justification of th EMS is rathr suspicious (p.118), and w rturn to its limitations at th nd of this chaptr. But th analysis is attractiv in svral ways.. First, it corrctly idntifis th ERM as an asymmtric systm in which som cntral banks sought an outsid sourc (th Bundsbank s strict anti-inflationary policy stanc) to scur lowr inflation. Scond, thir modl is linar and simpl, vn though it is a two-country modl. Th variabls ar dfind as prcntag dviations from thir (original) quilibrium valus, and tak th valu zro at quilibrium. Th rlationship btwn th original modl (in lvls) and th linar modl (in logs) is clar and Walras Law holds in both vrsions. Thir modl is also convnint for driving th rducd form for th xchang rat, which allows us to confirm that xchang rats rspond to asymmtris. Third, by studying this analysis, w can larn about anothr important contribution to macroconomic thory. This is th Kydland-Prscott ( Ruls Rathr than Discrtion: Th Inconsistncy of Optimal Plans, Journal of Political Economy, vol. 85, pp.473-491, 1977) and Barro-Gordon ( Ruls, Discrtion and Rputation in a Modl of Montary Policy, Journal of Montary Economics, vol.12, pp. 101-121, 1983) structur of inflationary bias and tim inconsistncy. Thr ar no intrst rats and no capital flows in th vrsion of th Canzonri and Hndrson modl usd in Sction IV of Canzonri and Hndrson (1988). Notation: (*dnots forign variabls) m : nominal stock of mony supply u : dmand shock x : supply shock : nominal xchang rat y : aggrgat incom and supply n : mploymnt VI-3
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI n : mploymnt highr than lvl corrsponding to th natural rat of unmploymnt z : ral xchang rat: z p q : consumr pric indx p w : nominal wag rat p : domstic product pric Th modl: y 1 (CH1) n x y 1 n ' (CH2) (CH 3) (CH 4) (CH 5) (CH 6) x w p nx w p n m p y m p y x y z 1 y y (CH 7) (CH 8) y z 1 y y (CH 9) q 1 p p (CH 10) q 1 p p ' Equations (CH1) and (CH2) ar th aggrgat supply functions. Th rprsntativ firms in ach country maximis profit as pric takrs, rsulting in (CH3) and (CH4). (CH5) and (CH6) ar th LM quations, (CH7) and (CH8) ar th IS quations. In othr vrsions of th modl, dmand shocks ar addd to th IS quations. Consumr pric indics ar dfind in (CH9) and (CH10)., 0 and 0, 1. Th ndognous variagbls ar y, y, n, n, p, p, q, q, and th indpndnt quations ar (CH1) to (CH4), thr out of (CH5) to (CH8), (CH9) and (CH10). Only thr quations out of (CH5) to (CH8) ar indpndnt bcaus of Walras Law. If w count z as an ndognous variabl, it is dtrmind by th dfinition of z givn in th notation. ' Th xognous variabls ar x, x, m, m. Th nominal wag rats w and w ar st at th bginning of th priod and ar xognous during th priod. Tim inconsistncy and inflationary bias in th C&H modl Hr is how w and w ar st. At th bginning of th priod, montary policy authoritis announc th chang in mony supply for that priod ( m and m ). Having hard that announcmnt, unions st wags in such a way that mploymnt will b at th lvl consistnt with th natural rat of unmploymnt ( n 0 and n 0). In othr words, thy minimis th xpctd lvl of n and n whos rducd forms ar: VI-4
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI (CH11) (CH12) n m w n m w This minimisation rsults in workrs xpctation of m and w m and th othr hand, is to minimis thir loss functions: w m whr m and m ar th m. Th policy authoritis optimisation problm, on 2 2 (CH 13) L1 2 nn q 2 2 (CH 14) L 1 2 n n q and Th authoritis car about both mploymnt and inflation (by stting last priod s q q qual to zro, q and q thmslvs can b intrprtd as inflation rats). n and n ar highr than mploymnt lvls corrsponding to th natural rat of mploymnt. Whn n and n ar zro, policymakrs and unions want th sam rat of mploymnt, i.. th rat corrsponding to th natural rat of unmploymnt. Whn n and n ar positiv, policymakrs want mploymnt to b highr. In such a cas, th montary policis suffr from tim-inconsistncy and thr is inflationary bias. In othr words, onc unions st thir nominal wags, authoritis hav an incntiv to switch to a highr rat of mony supply growth, rducing ral wags and incrasing mploymnt. Italy and Grmany in th ERM Canzonri and Hndrson (ibid.) apply this framwork to th ERM, by assuming that th forign country, Italy, has a strongr inflationary bias than th hom country, Grmany. In othr words, n n. To concntrat on th rlationship btwn inflationary biass and choic of xchang rat rgims, th supply shocks ar st to zro. Whn th two countris adopt floating xchang rats, both montary authoritis minimis thir rspctiv losss, taking ach othrs montary policis as givn. This corrsponds to Nash quilibrium btwn th two. Whn th two ntr th ERM, th ERM is an asymmtric systm in which Grmany minimiss its loss, knowing that Italy taks on th ntir burdn of intrvntion to maintain th Dutsch Mark-Italian lira rat VI-5
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI constant. In othr words, Grmany is th ladr and Italy is th followr in this rgim. Italy chooss to maintain m qual to m, and Grmany minimiss L givn m m. Mathmatically, th Nash and ERM quilibria ar drivd by substituting th rducd forms for n, n, q and q into th loss functions and calculating th first ordr conditions for minimisation with rspct to m (and Th rducd forms for n and unions into (CH11) and (CH12), m in th cas of Nash quilibrium). n ar, by substituting th lvls of w and w st by (CH11 ) (CH12 ) n mm n m m. W can s that in this modl, th ndognous variabls n and n do not rflct conomic intrdpndnc; thy dpnd only on xognous variabls of thir own conomy. In contrast th rducd forms for q and q show th conomic intrdpndnc: (CH15) q m 1 m m m m (CH16) q m m m m m 2 whr 1 1,, 1/. Whn calculating th first ordr conditions for floating xchang rats, th xpctd mony supply changs m and m ar tratd as givn. On intrprtation is that policymakrs act as Nash playrs not just against ach othr but also against unions, and tak th unions stratgis as givn in thir optimisation. Or w could simply say that wags ar st by unions first, and bcom fixd by th tim th policymakrs ar optimising. In any vnt, onc th first ordr conditions ar drivd, w solv thm simultanously for th Nash quilibrium valus of m and lvls of m and m that actually matrialis, which ar unions nd up corrctly xpcting th mony supply changs. Whn solving for th ERM quilibrium, w first substitut m. At this point, w must substitut th m m and m m m m sinc into L, thn driv th first ordr condition for minimising L with rspct to m. Again w trat m as givn at this stag. Onc w hav th first ordr condition, w us m m to solv for th quilibrium lvl of m, which is qual to m. m and m m and VI-6
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI Dos inflation go down by joining th ERM? From th quilibrium lvls of m and m, w can calculat n, rsults rgarding n and n, q and q. Th n ar actually not vry surprising, th structur of th analysis is such that thy both rmain at zro undr both flxibl xchang rats and ERM. Th policymakrs ffort to incras mploymnt byond th lvl corrsponding to th natural rat of unmploymnt coms to naught. What is mor intrsting in th prsnt contxt is whthr th inflation rats diffr according to which xchang rat rgim is adoptd. From (CH15) and (CH16), q m and q m undr m m and m m. Hnc undr floating xchang rats, q N n q N n and undr ERM, q ERM n q ERM Evidntly, th two countris inflation rats convrg undr ERM. And by subtracting th inflation rats undr floating xchang rats from th inflation rats undr ERM, w can confirm th following. Th inflation rat for Italy dclins by joining th ERM, if th initial gap in th inflation bias ( n n ) is larg nough. Th inflation rat for Grmany incrass by joining th ERM. This is bcaus joining ERM frs Grmany from any concrn ovr th xchang rat; Italy will tak car of th stabilisation of th DM-lit rat. Whn intrprting this lattr rsult, w should kp in mind that th strong anti-inflationary stanc of th Bundsbank rsts on historical xprinc, not incorporatd in this analysis. Lssons from th Canzonri and Hndrson analysis of ERM As mntiond bfor, Canzonri and Hndrson find ths rsults to b imprfct justification of th ERM (ibid. p.118). Thy provid thr rasons. On is that Grman inflation is supposd to go up by joining. W hav alrady commntd on this point. VI-7
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI Th scond rason is that thy find no obvious rason why Italy should find it asir to commit to a fixd xchang rat than to a valu for th mony supply. Th third rlatd rason is that th distinction btwn commitmnt to an xchang rat valu and commitmnt to a mony-supply valu is not vn clar without uncrtainty. Rgarding th scond and third points, w should rmmbr that commitmnt to an xchang rat valu is an intrnational commitmnt. Th intrnational rputation of a nation is at stak. Judging from th way th ERM not only survivd but ld to mor advancd stags, and that inflation rats of mmbrs of th ERM and th singl currncy tndd towards convrgnc, thr sms to hav bn a mchanism similar to gaiatsu (xtrnal prssur) in Japan. Using gaiatsu, domstically unpopular policis can b pushd through. Estimats for 2012 and 2013. Sourc: IMF World Economic Outlook Databas, Octobr 2012, http://www.imf.org/xtrnal/pubs/ft/wo/2012/02/wodata/indx.aspx Thus on important implication of th Canzonri and Hndrson analysis is th importanc of commitmnt ( tying on s hands ). Anothr thing th analysis tachs us is th importanc of policy disciplin. A country loss montary policy autonomy in a fixd xchang rat systm, unlss th country is th ladr of th systm. Th ladr maintains montary policy autonomy, and assigns its montary policy to domstic VI-8
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI stabilisation. Th followrs assign thir montary policis to xchang rat stability. Th ladr has mor frdom aftr joining th rgim, which could lad to highr inflation as shown by th Canzonri and Hndrson analysis. But such a fixd xchang rat arrangmnt is unlikly to last. Rcall that th followrs ar ffctivly importing th montary policy of th ladr. If th ladr allows high inflation to prsist, this taks away an important conomic rason for th followrs to stay in th systm. Evntually thy will dcid to lav. This is on important rason why th Brtton Woods systm brok down. Hnc, th prsistnt anti-inflationary stanc on th part of th Bundsbank was critical to th nduranc of th ERM, which was an important stp along th path towards montary unification in Europ. In th run-up to th introduction of th singl currncy, not only montary disciplin but also fiscal disciplin was obsrvd in Europ. Unprcdntd fforts at montary and fiscal consolidation wr mad. Ndlss to say, this was in ordr to b judgd to hav mt th Maastricht critria, a must for countris that wantd to join th first group of countris to introduc th uro. Onc th uro was introducd howvr, thr was lss of th incntiv. Th budgtary disciplin of th Maastricht critria was carrid on as Th Stability and Growth Pact (http://c.uropa.u/conomy_financ/sgp/indx_n.htm). But this pact was not ffctiv; mmbrs, including Grmany and Franc, brachd it. Th SGP was rvisd onc, but not sufficintly. Thr was no run-away inflation in th Euro ara, and th dficit-to-gdp ratios nvr rachd th lvl in Japan, but vidntly all was not wll. Th crisis starting in 2009 mad it painfully clar that conomic govrnanc within th Euro ara rquird som srious rviw. At first, th Euro ara was mor of a horrifid bystandr to th turmoil in th UK and th USA, causd by th Lhman shock. Thn in Octobr of 2009, a nw, Socialist govrnmnt ld by Prim Ministr Papandrou cam into powr in Grc. Bfor long, th world was told that th ratio of Grc s govrnmnt dficit to GDP was around 13%, much highr than th prvious govrnmnt had admittd. Markt participants lost confidnc in Grc s ability to pay back its dbt. Th lack of confidnc sprad to Portugal, Irland and Spain. In spit of th agrmnts involving th Troika (th IMF, th ECB and th Europan Commission) on rscu packags, and initiation of rform on th part of th troubld countris, thr was vn talk of a possibl brak-up of th Euro ara. Many blamd th uro for th crisis, arguing that th uro should not hav bn introducd in th first plac, bcaus th uro ara was not an Optimum Currncy Ara. As w hav sn in this lctur, asymmtris coxist badly with a systm of fixd VI-9
Sahoko KAJI --- Opn Economy Macroconomics Lctur Nots VI xchang rats (or singl currncy). In that sns, it is not surprising that Europ s singl currncy has run into troubl. Th Euro was xpctd to rduc asymmtris in th uro ara, as mmbrs convrgd towards fiscal consolidation and comptitivnss. Today, th Europans ar awar that thir govrnanc structur was not sufficint to nsur such a convrgnc. Europ mbarkd on a wholsal rform of govrnanc, including but not only th SGP. If a singl currncy systm is quippd with an ffctiv mchanism to nsur convrgnc towards fiscal sustainability and high productivity, it should bring about stability and prosprity. Grmany was first among th Euro ara countris to announc a major fiscal tightning plan, vn writing th balancing of th budgt into thir Constitution in 2009. All mmbr stats undrstand th importanc of fiscal sustainability, but th masurs must b accptabl to th votrs and b consistnt with conomic rcovry. Europ has only just startd on a journy in sarch of a bttr systm of conomic govrnanc. Thy ar ffctivly trying to find th answr to th qustion of how much sovrignty a nation must giv up to a supra-national ntity, if intgration is to succd. VI-10