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25/06/2011
1
INTERNATIONAL BUSINESS
ENVIRONMENT
SESSION 6
Regulating International Exchange: the
International Monetary System
CAUTION!
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SLIDES ARE NOT ENOUGH TO FULLY GRASP THE
COURSE CONTENTS
YOU ARE ADVISED TO:
Take notes and participate during the class
Read reference textbooks and other materials as
recommended
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The environment of international business (reminder)
INTERNATIONAL ENVIRONMENT
National trade
policies
Global economic regulation
Intl. monetary
system
Regional agreements
DOMESTIC / FOREIGN ENVIRONMENT
Culture
Political/legal systems
Economic system
Economic policies
FIRM
Structure Strategy Management
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Today's questions
1. What are foreign exchange markets? What are their functions?
2. What is the International Monetary System (IMS)? What has been its evolution since the early XXth Century? What is its structure today?
What are the economic and business implications of fixed vs. flexible exchange rates? Of a monetary union like the Eurozone?
3. What is the role of the IMF in managing the IMS and fostering international exchange?
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AN INTRODUCTION TO THE INTERNATIONAL
MONETARY SYSTEM
Section 1
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Preliminary definitions
The foreign exchange market (FOREX) is a market for converting the currency of one country into that of another country
The exchange rate is the rate at which one currency is converted into another
The international monetary system is made up of the institutional arrangements that countries adopt to govern exchange rates
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Exchange rates
Direct exchange rate
Direct quote
Price of the foreign currency in terms of home currency (e.g. USD/EUR)
Indirect exchange rate
Indirect quote
Price of the home currency in terms of the foreign currency (e.g. EUR/USD)
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USD / EUR^
Quantity of EUR
Exchange rate determination (1)
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Exchange rates are determined by the demand and supply for different
currencies
depending on
Inflation
Interest ratesMarket psychology
(bandwagon effect)
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Foreign exchange regimes (1)
Floating exchange rate: the demand for a country’s currency is a function of the demand for (1) its goods and services and (2) for financial assets denominated in its currency
Dirty/Managed float: a country tries to hold the value of its currency within some range of a reference currency ( free float)
Fixed exchange rate : countries fix their currencies against each other
The Central bank counteracts the demand and supply forces of the domestic currency, holding its value constant
Pegged exchange rate: a country fixes the value of its currency relative to a reference currency
Currency board: a country commits to converting its domestic currency on demand into another currency at a fixed exchange rate
To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued
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Foreign exchange regimes (2)
Monetary unions (currency unions): two or more countries sharing a single currency monitored and controlled by one central bank
Lato sensu: different currencies having a fixed mutual exchange rate monitored and controlled by several central banks with closely coordinated monetary policies
Dollarization: use of a foreign currency in parallel to or instead of the domestic one (not only applied to usage of the USD)
Monetary dollarization: the use of foreign currency and deposits as money in parallel with national currency
Financial dollarization: the use of foreign currency for financial transactions
Real dollarization: the use of foreign currency for pricing wages, goods and services
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The foreign exchange policy
Under a "managed float" system, monetary authorities are able to control the exchange rate of the domestic currency in order to influence domestic economic conditions
Inflation
Economic growth
External trade
Various tools include
Increasing domestic interest rates will lead to foreign capital inflow and therefore to an increase of the demand for that currency (appreciation)
Selling domestic currency against another one will lead to its depreciation
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The effects of currency variations
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Higher price of imports Stimulus to exports
Decreased returns on investment Increased cost attractiveness
EXAMPLE:
CURRENCY DEPRECIATION
Inflationary pressure in the short-runImproved trade balance in the mid-run (J-curve, under
Marshall-Lerner Condition)
Portfolio investment outflowsPossible foreign direct investment inflow
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Foreign exchange risk
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This risk usually affects businesses that export and/or import, but it can also affect investors
making international investments.
If money must be converted to another currency to make a certain investment, then any changes in
the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back
into the original currency.
http://www.investopedia.com/terms/f/foreignexchangerisk.asp
Floating exchange rates and business management
International Monetary System
Business strategyExchange movements can have a major impact on the competitive position of
businesses
Corporate-government relationsBusinesses can influence government
policy towards the international monetary system
Currency managementSpeculative buying and selling of
currencies can create volatile movements in exchange rates
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History of the IMS: key periods
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Late XIXth Century – 1914
Gold Standard: currencies are pegged to / convertible into gold
Inter-war period
Various systems changing over time
1944-1976
Bretton Woods / Gold exchange standard: All currencies are fixed to gold, only the U.S. dollar is directly convertible to gold
1976 - ...
Washington Consensus: floating exchange rates, currencies are not convertible to gold
The Gold Standard
Pegging currencies to gold and guaranteeing convertibility
Dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value
→Payment for imports was first made in gold or silver
→Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate
Worked from the 1870s until the 1st World War
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The end of the Gold Standard
During the 1st World War, many governments financed their war expenditures by printing money, thus generating
inflation
People lost confidence and demanded gold for their currency, putting pressure on countries' gold reserves,
and forcing them to suspend gold convertibility
By 1939, the gold standard had come to an end
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The inter-war period
No stable International Monetary System
Gold standard readopted in 1920s in US, UK, France,
Switzerland
Dropped during Great Depression
Hyperinflationary finance in Germany, Austria, Hungary,
Poland
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The Bretton Woods system
A fixed exchange rate system
All currencies are fixed to gold, but only the U.S. dollar is directly convertible to gold (35 USD/ounce)
Devaluations could not to be used for competitive purposes
A country cannot devalue its currency by more than 10% without IMF approval
Two multinational institutions
The International Monetary Fund (IMF): maintain order in the international monetary system
The World Bank: promote general economic development
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The case for fixed exchange rates (1)
Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates (see Mundell's incompatibility triangle)
Having to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates
Fixed exchange rates prevent "beggar-thy-neighbour" competitive devaluation policies aimed to generate a trade surplus
From a business standpoint, fixed exchange rates mean a reduction of obstacles to trade and capital flows
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The case for fixed exchange rates (2)(Mundell's incompatibility triangle)
Free movement of capital
Fixed exchange rates
Autonomous monetary
policy
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The collapse of the Bretton Woods system
Bretton Woods worked well until the late 1960s
Huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation
Other countries increased the value of their currencies relative to the dollar, in response to speculation the dollar would be devalued
Because the system relied on an economically well managed U.S., the system was strained to the breaking point
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The end of Bretton Woods: Jamaica Agreements
IMF Jamaica meeting (1976)
Fixed exchange rate system is abandoned
IMF is in charge of overseeing global financial system
Total annual IMF quotas increased to
$41 billionPar values
against gold and USD are
abandoned
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The IMS today: foreign exchange regimes in 2007
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The case for floating exchange rates
1. Monetary policy autonomy (see incompatibility triangle)
Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity
2. Automatic trade balance adjustments
Floating rates help adjust trade imbalances
→ Under the Bretton Woods system, a country's permanent trade deficit could not be corrected by domestic policy; the IMF would have to agree to a currency devaluation
3. From a business standpoint, floating exchange rates generate uncertainty and risks (exchange risks) as well as opportunities (competitiveness, attractiveness)
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The case for monetary unions
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A monetary (or currency) union is considered necessary when floating exchange rates could impede regional trade and the ability
to create an integrated economy (e.g. Eurozone)
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The case of the European Monetary Union
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The case of the European Monetary Union
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The case of the European Monetary Union
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Malta and Cyprus joined on
January 1, 2008
The euro is the official currency
in Kosovo and Montenegro
Slovenia joined on January 1,
2007
Slovakia joined on January 1,
2009
Estonia joined on January 1,
2011
The Eurozone today: an unstable setting
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The eurozone remains a hybrid. It is a monetary union but not a political union, and so countries such as
Ireland have had to go it alone in bailing out struggling banks. There is a clear distinction between the US,
where the government has financial clout across all 50 states, and the EU.
In the long term, monetary unions do not survive without political union, and so […] there are pressures both for closer integration and for disintegration. The
crisis could strengthen those who argue that the halfway house is inherently unstable and will remain so
until there is fiscal as well as monetary union. On the other hand, the growing threat of recession may make
some countries question the value of remaining in a monetary union.
http://www.guardian.co.uk/business/2008/oct/06/creditcrunch.eu
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Other cases of monetary unions
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West AfricanEconomic and Monetary Union
Benin, Burkina Faso, Cote d'Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo
CFA franc (XOF)(fixed to EUR)
1 EUR =655.957 CFA francs
Central AfricanEconomic and Monetary Community
Cameroon, Central African Republic, Chad, Republic of the Congo, Equatorial Guinea, Gabon
CFA franc (XAF)(fixed to EUR)
1 EUR =655.957 CFA francs
Eastern CaribbeanCurrency Union
Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines, Anguilla and Montserrat
Eastern Caribbean dollar (XCD)(pegged to USD)
1 USD = 2.7 EC$
REGULATING THE INTERNATIONAL MONETARY
SYSTEM: THE INTERNATIONAL MONETARY FUND
Section 2
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Introduction example: Belarus
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Belarus said it had asked the International Monetary Fund for an emergency loan of up to $US8 billion, hoping to stave off a financial crisis in the ex-Soviet
republic. The government announcement came a day after it froze prices on a number of basic foodstuffs until July 1 and a week after a 36% devaluation of
the rouble failed to persuade banks and Belarussians to resume trading at official rates. It signals the growing economic pressure on President Alexander
Lukashenko, who spent heavily ahead of elections last year and promised to raise wages sharply while rejecting the need for Western help.
The IMF issued $US3.5 billion in loans to Belarus from 2009 to 2010 and has sent a mission to assess the situation in the country of almost 10 million
people, long shielded by the government's Soviet-style economic policies. "In my view the IMF will respond positively," said analyst Ivan Tchakarov. "At the
end of the day they have to agree on the conditions and the conditions will be very strict, very stringent, but they will be purely macroeconomic conditions
and will not relate to political issues or sanctions."
Conditions could include the liberalising of the exchange rate. Even after the central bank move last week, the black market quotes the rouble at about
6,000 per dollar, much weaker than the official rate of 4,970 per dollar.
Business Spectator, 1 Jun 2011
The International Monetary Fund (IMF)
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Means: combination of discipline and flexibility
Impose monetary discipline on countries, thereby curtailing price inflation
Put a brake on competitive devaluations and bring stability to the world trade environment
Lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment
UN agency created in July 1944, based in Washington (US)
Objectives:
Avoid a repetition of the chaos that occurred between the wars
Assist the reconstruction of the world's international payment system
Stabilize exchange rates
… promote international exchange
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The IMF after Bretton Woods
Since many of the original reasons for the IMF no longer existed, the organization had
to redefine its mission
Critics claim that IMF policies in these countries have
actually made the situation worse
Now focuses on lending money to countries
experiencing financial crises, using IMF deposits (Special
Drawing Rights)
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The IMF today
187 members in 2010
Objectives: foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, reduce poverty
Means
Surveillance: follow up of members' macroeconomic policies, in particular those with an impact on exchange rates and the balance of payments
Conditional loans to countries that experience serious financial and economic difficulties, using IMF deposits (Special Drawing Rights)
http://www.imf.org/external/np/exr/facts/glance.htm
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The organisation of the IMF (http://www.imf.org/external/about/govstruct.htm)
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The quota system
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Upon joining, each member of the IMF is assigned a quota, based broadly on
its relative size in the world economy
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Special Drawing Rights
USD44%
EUR34%
JPY11%
GBP11%
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The Special Drawing Right (SDR) is an international reserve asset based on a basket of currencies. It was created by the IMF in 1969 to supplement the
existing official reserves of member countries.
http://www.imf.org/external/about/sdr.htm
IMF loans
Concessional loans to low-income countries (LICs)
Extended Credit Facility (ECF): main tool for providing medium-term support to LICs with protracted balance of payments problems
Standby Credit Facility (SCF): financial assistance to LICs with short-term balance of payments needs
Rapid Credit Facility (RCF): rapid financial assistance (limited conditionality) to LICs facing an urgent balance of payments need
Non concessional loans
Stand-By Arrangements (SBA): designed to help countries address short-term balance of payments problems
Flexible Credit Line (FCL): for countries with very strong fundamentals, policies, and track records of policy implementation, crisis prevention purposes
Extended Fund Facility: established in 1974 to help countries address longer-term balance of payments problems requiring fundamental economic reforms
(http://www.imf.org/external/np/exr/facts/howlend.htm)25/06/2011 JG DITTER _ International Business Environment 40
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The IMF in action ...
http://www.imf.org/external/mmedia/view.asp?eventID=226
What are the problems faced by the fictitious economy described in
this movie? What does the IMF do to help solve these problems?
According to you, why are IMF "therapies" often criticised? What are their possible shortcomings?
What are the implications of IMF action from an business standpoint?
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Structural adjustment programmes (SAPs)
IMF loans
Conditionality: reduce domestic fiscal imbalances
Tax increasePrice
liberalisationMarket
deregulationTrade
liberalisation
Privatisation of state owned
companies
Pressure on domestic demandExport-led growth
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43
SAPs vs. the Washington Consensus
1. Fiscal policy discipline
2. Redirection of public spending toward education, health and infrastructure investment
3. Tax reform – Flattening the tax curve
4. Interest rates that are market determined and positive (but moderate) in real terms
5. Competitive exchange rates
6. Trade liberalization –replacement of quantitative restrictions with low and uniform tariffs
7. Openness to foreign direct investment
8. Privatization of state enterprises;
9. Deregulation – abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions
10. Legal security for property rights
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The IMF in question
Support to military dictatorship(1970-80s)
Economic and social hardship caused by
structural adjustment programmes
Moral hazard exacerbation
An institution dominated by
developed economies and the "big business"?
Government in need of capital would turn down conditional IMF loans, crowding-out the institution's resources
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"The IMF is hurting the poor ..."
Turkey and Latvia were in the news last week, having joined the roster of governments whose IMF disbursements are being withheld because they find it politically impossible to impose the required punishments on their citizens. The IMF sees these measures as necessary and pre-determined – in most cases by the borrowing countries' having run-
up unsustainable external or budget imbalances. But in fact the IMF has a long track record – dating back decades – of imposing unnecessary and often harmful conditions
on borrowing countries.
Latvia missed a 200 million euro disbursement from the IMF in March for not cutting its budget enough. According to press reports, the government wants to run a budget
deficit of 7% of GDP for this year, and the IMF wants 5%. Latvia is already cutting its budget by 40%, and is planning to close some public hospitals and schools in order to
make the IMF's targets, prompting street protests.
In almost all of its standby arrangements negotiated over the last year, the IMF has included conditions that will reduce output and employment in situations where
economies are already shrinking.
http://www.guardian.co.uk/commentisfree/cifamerica/2009/may/13/imf-us-congress-aid
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The global crisis: a new authority for the IMF?
→ Supporting global fiscal stimulus
→ Lender of last resort: more than USD 280 Bn lent to countries hit by the crisis—including Greece, Ireland, Portugal, Romania, and Ukraine—and extended credit to Mexico, Poland, and Colombia.
→ Helping low-income countries fight the crisis
→ Reinforcing multilateralism
→ Reforming the international financial system
→ Rethinking macroeconomic principles
http://www.imf.org/external/about/onagenda.htm
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A limited influence?
25/06/2011 JG DITTER _ International Business Environment 47
Many prominent academic economists see a basic contradiction in the global system of oversight on trade and currency. “Many of us would like to see the
WTO-style commitments — with people’s feet being held to the fire — at other international agencies, like the IMF,” said Jagdish Bhagwati, a Columbia
University economist. […]
World leaders set up two institutions after World War II, now known as the WTO and the IMF, to reduce the risk of another Great Depression. Unlike its
predecessor, which had weak arbitration panels whose rulings could be easily blocked by the losing country, the trade organization has had powerful tribunals
since 1995. These tribunals can clear the way for the imposition of sanctions running into the billions of dollars. […]
The monetary fund has not acquired similar powers to the trade organization. IMF policies call for it to disclose documents and information on a timely basis,
with the deletion only of market-moving information. But under the rules a member country may decide to withhold a report […]
New York Times, March 14, 2010
THE INTERNATIONAL MONETARY SYSTEM'S
DEFICIENCIES
Section 3
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Since 1973, a series of crises
Banking crises refer to a situation in which a loss of confidence in the banking system leads to a "run on the banks", as individuals and companies withdraw their deposits
Currency crises occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates
Foreign debt crises are situations in which a country cannot service its foreign debt obligations, whether private sector or government debt
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Since 1973, a series of crises (ctd)
Latin American debt crisis (1980s)
Black Monday (October 19, 1987): global stock market crash
Japanese real estate bubble collapse (1990s)
EMS currency crises (1992-93)
Mexican currency crisis (1994)
Southeast Asian financial crisis (1997)
Russian debt crisis (1998), leading to the collapse of LTCM
Turkish financial crisis (2001)
Dotcom bubble burst (2001)
Argentine currency crisis (2002)
"Subprime" crisis ... leading to global financial crisis (2007-2009)
European foreign debt crisis (2008 - ...)
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Undervalued yuan
Weakening US Dollar
Pressure on Brazilian real, Turkishlira, etc.
Strong euro
Current issues: currency and BoP imbalances
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Currency wars?
China has been criticised by the EU and, especially, by the US for keeping its currency at an artificially low level, meaning that its exports are cheaper
worldwide and hindering export-led recovery from recession in the developed world. But Wen Jiabao […] predicted social unrest in China if there was a rapid
rise in the yuan. "Many of our exporting companies would have to close down," Wen said. "Migrant workers would have to return to their villages. If China saw
social and economic turbulence, then it would be a disaster for the world."
His remarks come amid fears of a "currency war" between western nations and the developing world and as the head of the International Monetary Fund
waded into the row, warning governments against using exchange rates as a weapon. Dominique Strauss-Kahn told the Financial Times: "There is clearly the idea beginning to circulate that currencies can be used as a policy weapon." He added: "Translated into action, such an idea would represent a very serious risk
to the global recovery… Any such approach would have a negative and very damaging longer-run impact."
http://www.guardian.co.uk/business/2010/oct/06/currency-war-warning-imf-chief
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The euro and the European debt crisis
Single currencySingle monetary policy
(low) interest rates at Eurozone level
Large amounts of cheap money available
Real estate bubble, private debt(Ireland, Spain)
Unrestrained public spending, public debt
(Greece, Portugal)
The euro and the European debt crisis
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During the years of easy money, wages and prices in the crisis countries rose much faster than in the rest of Europe. Now that the money is no
longer rolling in, those countries need to get costs back in line.
But that’s a much harder thing to do now than it was when each European nation had its own currency. Back then, costs could be
brought in line by adjusting exchange rates — e.g., Greece could cut its wages relative to German wages simply by reducing the value of the
drachma in terms of Deutsche marks.
Now that Greece and Germany share the same currency, however, the only way to reduce Greek relative costs is through some combination of German inflation and Greek deflation. And since Germany won’t accept
inflation, deflation it is.
The problem is that deflation — falling wages and prices — is always and everywhere a deeply painful process. It invariably involves a
prolonged slump with high unemployment. And it also aggravates debt problems, both public and private, because incomes fall while the debt
burden doesn’t.
By PAUL KRUGMAN, New York Times, April 30, 2010
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A "euro trap"?
Debt / competitiveness crisis
Austerity and competitive deflation
Depressive impactSide effects on trade partners
DevaluationQuit eurozone
Inflation, higher interest ratesRun on banks
Costs of introducing new currency
Debt restructuring
Lost assets for European banks
The irish example
New York Times, June 28, 2010
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A two-layer Europeh
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A need for a better regulation …
Adjustment mechanism for dealing
with global imbalances.
Regulation of international capital
flows
Nature and role of reserve currency
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An emerging forum: the G-20 (http://www.g20.org/index.aspx)
The Group of 20, or G-20, is an international body that meets to discuss economic issues. It is a forum for cooperation and consultation on matters pertaining to the international financial system
It gathers finance ministers and central bank governors from 19 of the world's largest national economies, plus the European Union
Its members represent about 90 percent of the world's gross national product, 80 percent of world trade (including trade within the European Union) and two-thirds of the global population
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