Lecture 11Lecture 11

International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005

Prof. Steve CunninghamProf. Steve Cunningham

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Monetary Policy InstrumentsMonetary Policy Instruments

Required ReservesRequired Reserves Permanent Standing Facilities Permanent Standing Facilities Open Market OperationsOpen Market Operations

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Required ReservesRequired Reserves

Reserve deposits of banks held at the NCBs.Reserve deposits of banks held at the NCBs. An increase in the required reserve ratio An increase in the required reserve ratio

amounts to contractionary policy since it amounts to contractionary policy since it reduces excess reserves and lending.reduces excess reserves and lending.

A decrease in the required reserve ratio A decrease in the required reserve ratio amounts to expansionary policy.amounts to expansionary policy.

Earn interest at a rate equal to the repo rateEarn interest at a rate equal to the repo rate In 2004, the legal required reserve ratio in In 2004, the legal required reserve ratio in

the EU was between 1.5 and 2.5 percent of the EU was between 1.5 and 2.5 percent of the bank’s liabilities.the bank’s liabilities.

Rarely used for short-term policy purposes.Rarely used for short-term policy purposes.

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Permanent Standing Permanent Standing FacilitiesFacilities

Similar to the U.S. Fed’s “Discount Similar to the U.S. Fed’s “Discount Window”.Window”.

The ECB provides overnight emergency The ECB provides overnight emergency loans to banks short of liquidity.loans to banks short of liquidity. Some of the loans are made in the form of Some of the loans are made in the form of

overnight repurchase agreements,overnight repurchase agreements, Others are based on a collateral agreement Others are based on a collateral agreement

wherein the borrower provides government wherein the borrower provides government securities to the NCB as collateral.securities to the NCB as collateral.

The interest rates on these loans is The interest rates on these loans is higher than other ECB rates.higher than other ECB rates.

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Permanent Standing Permanent Standing Facilities (2)Facilities (2)

Banks with excess overnight liquidity may Banks with excess overnight liquidity may deposit this at their NCBs.deposit this at their NCBs. This is the ECB’s short-term standing deposit This is the ECB’s short-term standing deposit

facility.facility. Such deposits receive interest based on the Such deposits receive interest based on the

marginal deposit rate, the lowest of ECB rates.marginal deposit rate, the lowest of ECB rates. The spread between the deposit rate and The spread between the deposit rate and

borrowing rate form the bounds for overnight borrowing rate form the bounds for overnight market interest rates.market interest rates.

The Governing Council has the authority to The Governing Council has the authority to change the operating terms of the facility change the operating terms of the facility or discontinue it if necessary.or discontinue it if necessary.

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Open Market Operations Open Market Operations (OMOs)(OMOs)

These are the most important and most These are the most important and most often used monetary policy tools available often used monetary policy tools available to the ECB. to the ECB.

They are used to manage liquidity and They are used to manage liquidity and interest rates on a day-to-day basis.interest rates on a day-to-day basis.

There are four distinct categories regarding There are four distinct categories regarding the “aim, regularity, and procedures” of the “aim, regularity, and procedures” of open market operations. These are:open market operations. These are: Main refinancing operationsMain refinancing operations Longer-term refinancing operationsLonger-term refinancing operations Fine-tuning operationsFine-tuning operations Structural operationsStructural operations

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OMOs: Main Refinancing OMOs: Main Refinancing OperationsOperations

To cover short-run liquidity needs, banks may To cover short-run liquidity needs, banks may borrow from their NCB.borrow from their NCB. The NCBs make the loans by buying high-grade bonds The NCBs make the loans by buying high-grade bonds

from the borrowing institutions which they hold as from the borrowing institutions which they hold as collateral. The borrowing institution promise to collateral. The borrowing institution promise to repurchase the same bonds in two weeks when their repurchase the same bonds in two weeks when their loans are repaid. loans are repaid.

The Governing Council sets the interest rate on The Governing Council sets the interest rate on the loans.the loans.

Commercial banks offer bids to supply liquidity, Commercial banks offer bids to supply liquidity, which result in reverse repos.which result in reverse repos.

This process provides an important monetary This process provides an important monetary tool, and the largest volume of refinancing to the tool, and the largest volume of refinancing to the Euro Area.Euro Area.

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OMOs: OMOs: Longer-Term Refinancing Longer-Term Refinancing OperationsOperations

Implemented through regular refinancing Implemented through regular refinancing held once a month. held once a month.

These loans have a maturity of 3 months.These loans have a maturity of 3 months. Those seeking the loans submit bids, and Those seeking the loans submit bids, and

the loans are awarded competitively. the loans are awarded competitively. These are a relatively small part of the These are a relatively small part of the

ECB’s refinancing volume, and are not ECB’s refinancing volume, and are not used to provide policy signals to the used to provide policy signals to the marketplace.marketplace.

Thus the ECBs are not setting the rate, Thus the ECBs are not setting the rate, but rather simply responding to bids.but rather simply responding to bids.

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OMOs: Fine-tuning OMOs: Fine-tuning OperationsOperations

These are used to smooth out These are used to smooth out fluctuations of interest rates that fluctuations of interest rates that may result from unexpected may result from unexpected volatility in the market.volatility in the market.

These are usually conducted These are usually conducted through:through: Outright transactionsOutright transactions Foreign exchange swapsForeign exchange swaps Collection of fixed-term depositsCollection of fixed-term deposits

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OMOs: Structural OperationsOMOs: Structural Operations

These are OMOs resulting from a These are OMOs resulting from a need of the Eurosystem to need of the Eurosystem to restructure its financial position in restructure its financial position in relation to the Euro Area financial relation to the Euro Area financial sector.sector.

The NCBs issue debt certificates, The NCBs issue debt certificates, altering the composition of the altering the composition of the balance sheet of both the balance sheet of both the Eurosystem and the financial Eurosystem and the financial institutions.institutions.

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Experience with the Euro:Experience with the Euro:Nominal US Exchange RateNominal US Exchange Rate

The euro was adopted on January 1, 1999.The euro was adopted on January 1, 1999. The Euro Area countries have agreed to let their currency The Euro Area countries have agreed to let their currency

float against all currencies that had joined the flexible float against all currencies that had joined the flexible exchange rate regime that followed Bretton Woods.exchange rate regime that followed Bretton Woods.

The euro was introduced at $1.168 relative to the US The euro was introduced at $1.168 relative to the US dollar, which was the US dollar-European Currency Unit dollar, which was the US dollar-European Currency Unit (ECU) official exchange rate on the last day of 1998. (ECU) official exchange rate on the last day of 1998.

That is, the euro replaced the ECU on a one-to-one basis.That is, the euro replaced the ECU on a one-to-one basis. The first recorded trading transaction of the euro took The first recorded trading transaction of the euro took

place in Australia on January 4, 1999 at $1.175.place in Australia on January 4, 1999 at $1.175. In Europe, the euro began trading at a rate of $1.1855.In Europe, the euro began trading at a rate of $1.1855.

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Experience with the Euro:Experience with the Euro:Nominal US Exchange Rate (2)Nominal US Exchange Rate (2)

Almost immediately the euro started depreciating Almost immediately the euro started depreciating against the US dollar.against the US dollar.

This trend continued until the end of 2000.This trend continued until the end of 2000. From mid 2000 to mid 2002, the euro was stable From mid 2000 to mid 2002, the euro was stable

against the dollar, bouncing around the $0.90 level.against the dollar, bouncing around the $0.90 level. In mid 2002 the euro began to appreciate against In mid 2002 the euro began to appreciate against

the dollar. the dollar. This concerned European businesses, the EU Council and This concerned European businesses, the EU Council and

the ECB because it implied that European exports were the ECB because it implied that European exports were becoming more expensive to Americans.becoming more expensive to Americans.

This could slow the sales of exports and damage their still-This could slow the sales of exports and damage their still-fragile economic expansions.fragile economic expansions.

The euro reached a high of $1.3633 on Dec. 28, The euro reached a high of $1.3633 on Dec. 28, 2004.2004.

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Dollar-Euro Nominal Exchange Dollar-Euro Nominal Exchange RateRate

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Experience with the Euro:Experience with the Euro:Other Nominal Exchange RatesOther Nominal Exchange Rates

The first 5 years experience of the The first 5 years experience of the exchange rates of the Japanese yen, exchange rates of the Japanese yen, UK pound sterling, Swiss franc, UK pound sterling, Swiss franc, Canadian dollar, South Korean won, Canadian dollar, South Korean won, and Chinese yuan were similar to that and Chinese yuan were similar to that of the US dollar.of the US dollar.

The first 5 were market driven, floating The first 5 were market driven, floating exchange rates, influenced periodically exchange rates, influenced periodically by government interventions.by government interventions.

The Chinese renminbi is pegged to the The Chinese renminbi is pegged to the U.S. dollar at 8.27 yuan to the dollar.U.S. dollar at 8.27 yuan to the dollar.

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Experience with the Euro:Experience with the Euro:Other Nominal Exchange Rates Other Nominal Exchange Rates (2)(2)

The Australian dollar (“the aussie”) is The Australian dollar (“the aussie”) is a “commodity exchange rate”, driven a “commodity exchange rate”, driven by movements in the prices of some by movements in the prices of some commodities that they heavily export.commodities that they heavily export.

The Swedish krona/euro exchange The Swedish krona/euro exchange rate has been stable because Sweden rate has been stable because Sweden was considering joining the EMU and was considering joining the EMU and was been preparing to adopt the euro.was been preparing to adopt the euro. As a result Sweden was obligated to As a result Sweden was obligated to

maintain a stable currency versus the maintain a stable currency versus the euro prior to joining the EMU.euro prior to joining the EMU.

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Experience with the Euro:Experience with the Euro:Other Nominal Exchange Rates Other Nominal Exchange Rates (3)(3)

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Experience with the Euro:Experience with the Euro:Other Nominal Exchange Rates Other Nominal Exchange Rates (4)(4)

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Nominal vs. Real Exchange Nominal vs. Real Exchange RatesRates

The nominal exchange rate is the rate that is quoted The nominal exchange rate is the rate that is quoted by banks and in the newspapers.by banks and in the newspapers.

It is the exact number of foreign currency units that It is the exact number of foreign currency units that can be exchanged for one unit of the domestic can be exchanged for one unit of the domestic currency.currency.

E.g., how many yen can a dollar buy today?E.g., how many yen can a dollar buy today? The nominal exchange rate does not tell us The nominal exchange rate does not tell us explicitlyexplicitly

the amount of goods and services that a domestic the amount of goods and services that a domestic currency unit (one dollar) would buy in the foreign currency unit (one dollar) would buy in the foreign country.country.

To determine this, we need to incorporate information about To determine this, we need to incorporate information about relative prices in the two countries as well.relative prices in the two countries as well.

The nominal exchange rate is also The nominal exchange rate is also bilateralbilateral, meaning , meaning it only relates the currencies of two countries.it only relates the currencies of two countries.

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Nominal vs. Real Exchange Nominal vs. Real Exchange Rates (2)Rates (2)

Real exchange rates reflect the buying Real exchange rates reflect the buying power of the domestic currency unit in power of the domestic currency unit in terms of the goods and services of the terms of the goods and services of the other country.other country.

Real exchange rates are still bilateral, Real exchange rates are still bilateral, but incorporate price index informationbut incorporate price index information. . Which price index?Which price index? Depending on whether Depending on whether

your interest was travel or importing, you your interest was travel or importing, you might use the a price index reflecting the might use the a price index reflecting the prices that the average consumer in the prices that the average consumer in the country faces, or you might use the country faces, or you might use the average price of the country’s exports.average price of the country’s exports.

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An “Average” Nominal Exchange An “Average” Nominal Exchange RateRate

Nominal Trade-Weighted Exchange Rate or Nominal Nominal Trade-Weighted Exchange Rate or Nominal Effective Exchange Rate (NEER). (“Trade-weighted Effective Exchange Rate (NEER). (“Trade-weighted dollar”)dollar”)

This is This is NOTNOT a bilateral exchange rate. a bilateral exchange rate. This is a weighted average of This is a weighted average of ALLALL the bilateral the bilateral

exchange rates of the country’s trading partners, exchange rates of the country’s trading partners, weighted according to the volume of trade (trade weighted according to the volume of trade (trade share) with each country.share) with each country.

In our case, this answers the question In our case, this answers the question “how is the “how is the dollar doing overall, against all other currencies?”dollar doing overall, against all other currencies?”

Because this is not relative to any single currency, it Because this is not relative to any single currency, it cannot be constructed as a typical exchange rate. It is cannot be constructed as a typical exchange rate. It is constructed like a price index, with a base year set at constructed like a price index, with a base year set at 100, and other time periods given in relative terms.100, and other time periods given in relative terms.

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Nominal Effective Exchange Nominal Effective Exchange RateRate

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Nominal Effective Exchange Nominal Effective Exchange Rate (2)Rate (2)

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An “Average” Real Exchange An “Average” Real Exchange RateRate

This is the Real Trade-Weighted This is the Real Trade-Weighted Exchange Rate or Real Effective Exchange Rate or Real Effective Exchange Rate (REER). Exchange Rate (REER).

These incorporate price indexes for the These incorporate price indexes for the countries involved, and are constructed countries involved, and are constructed as indexes with a base year at 100.as indexes with a base year at 100.

A decline in the REER implies that a A decline in the REER implies that a country’s exports are cheaper to country’s exports are cheaper to foreigners, which should improve the foreigners, which should improve the country’s trade balance. country’s trade balance.

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Real Effective Exchange RateReal Effective Exchange Rate

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Real Effective Exchange Rate Real Effective Exchange Rate (2)(2)

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Why an EU Constitution?Why an EU Constitution?

It has outgrown its informal rules.It has outgrown its informal rules. Began in 1951 as a six-nation economic Began in 1951 as a six-nation economic

alliance.alliance. By 1995 it had 15 countries and rivaling the By 1995 it had 15 countries and rivaling the

U.S. in economic power.U.S. in economic power. Now it is a confederation of 25 countries, with Now it is a confederation of 25 countries, with

more to come.more to come. Many decisions still require unanimous Many decisions still require unanimous

agreement of the members.agreement of the members. It was hoped that a constitution would It was hoped that a constitution would

streamline the voting process and create streamline the voting process and create more of a federal structure like the U.S.more of a federal structure like the U.S.

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Definition and objectives of the EUDefinition and objectives of the EU

• A Union of peoples and States

•The underlying values of the EU

• Multiple objectives

• Relations between the EU and the Member States based on the principle of loyal cooperation

• A Union with legal personality

• Exercising competences: the Community model

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EU

OBJECTIVES

EU

VALUES

• Respect for human dignity

• Liberty

• Democracy

• Rule of law

• Respect for human rights and for minorities

• Pluralism, tolerance, justice

•Solidarity, non-discrimination

• Equality between women and men

• Internal objectives of the Union

• External objectives of the Union

Legal PersonalityLegal Personality

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Multiple ObjectivesMultiple Objectives

Promotion of peace, the EU’s values and the well being of its peoples

•The internal objectives of the Union•The external objectives of the Union

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Internal ObjectivesInternal Objectives

Sustainable development based on balanced economic growth and price

stability

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Internal Objectives (2)Internal Objectives (2)

A highly competitive social market economy aiming at A highly competitive social market economy aiming at full employment and social progressfull employment and social progress

COMBAT SOCIAL

EXCLUSION

PROMOTE JUSTICE

AND SOCIAL PROTECTIO

N

EQUALITYMEN /

WOMEN

SOLIDARITYBETWEEN

GENERATIONS

PROTECTIONOF THE RIGHTS OF

THE CHILD

ECONOMIC, SOCIAL AND TERRITORIAL COHESION

SOLIDARITY BETWEENSTATES

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Internal Objectives (3)Internal Objectives (3)

High level of protection and High level of protection and

improved quality of improved quality of

the environmentthe environment

Environment and scientific progressEnvironment and scientific progress

Promotion of scientific Promotion of scientific

and technical progressand technical progress

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Internal Objectives (4)Internal Objectives (4)

DiversityDiversity

Respect for the EU’s Respect for the EU’s

rich cultural rich cultural

and linguistic diversityand linguistic diversity

Safeguarding and enhancingSafeguarding and enhancing

Europe’s cultural Europe’s cultural

heritageheritage

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External ObjectivesExternal Objectives

The external objectives of the Union

Upholding and promoting the EU’s values and interests

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External Objectives (2)External Objectives (2)

Mutual respect between

peoples

Security

Peace

Solidarity

Free and fair tradeEradication of

poverty

Protection of

human rights

Protection of the rights

of the child

Respect for international

law

Respect for the principles

of the UN Charter

Sustainable development

of the earth

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Fundamental FreedomsFundamental Freedoms

• FREE MOVEMENT OF PERSONS

• FREE MOVEMENT OF GOODS

• FREE MOVEMENT OF SERVICES

THE 4 FREEDOMS OF THE UNION

• FREE MOVEMENT OF CAPITAL

NON-DISCRIMINATION

• NON-DISCRIMINATION

ON GROUNDS OF

NATIONALITY

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Fundamental Freedoms (2)Fundamental Freedoms (2)

Relations between the Union and the Member States based on the principle of loyal cooperation and on equality of Member States before the Constitution

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Fundamental Freedoms (3)Fundamental Freedoms (3)

RESPECT OF NATIONAL IDENTITIES

PRINCIPLE OF LOYAL COOPERATION

MEMBER STATES

EUROPEAN UNION

PRIMACY OF EUROPEANUNION LAW

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Legal PersonalityLegal Personality

European Union

LEGAL PERSONALITY

TAKING THE PLACE OF EXISTING LEGAL PERSONALITIES

The EU can:

Represent Europe, conclude treaties

Take legal action, belong to international organisations

The various Treaties currently governing Europe can be merged into a

constitutional Treaty

CONSTITUTIONAL

TREATY

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CitizenshipCitizenship

National National

citizenshipcitizenship

Union Union

citizenshipcitizenship

Right to move and reside freely within the territory of the Member States

Right to vote and to stand in European Parliament elections and in local elections

Right to enjoy, in the territory of a third country where the citizen’s Member State is not

represented, protection from any Member State’s diplomatic and consular authorities

Right to petition the EP, to apply to the Union Ombudsman

Right to write to the institutions and advisory bodies of the Union in any of the EU’s languages

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Exclusive Domain of the Exclusive Domain of the UnionUnion

• Customs union

• Competition rules necessary for the functioning of the internal market

• Monetary policy, for the Member States whose currency is the euro

• Conservation of marine biological resources under the common fisheries policy

• Common commercial policy

• Conclusion of an international agreement when :

- its conclusion is provided for in a legislative act of the Union

- It is necessary to enable the Union to exercise its internal competence

- Insofar as its conclusion may affect common rules or alter their scope

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Shared DomainShared Domain•Internal market

•Social policy, for aspects defined in Part III

•Economic, social and territorial cohesion

•Agriculture and fisheries, excluding the conservation of marine biological resources

•Environment

•Consumer protection

•Transport, Trans-European networks, Energy

•Area of freedom, security and justice

•Common safety concerns in public health matters, for aspects defined in Part III

•Research, technological development and space

•Development cooperation and humanitarian aid

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Complicated?Complicated? The US Constitution is 7 articles and 27 The US Constitution is 7 articles and 27

amendments.amendments. The proposed European constitution contains The proposed European constitution contains

448 articles, covering more than 300 pages.448 articles, covering more than 300 pages. It is filled with exceptions to preserve the It is filled with exceptions to preserve the

rights of specific nations to opt out of certain rights of specific nations to opt out of certain regulations. regulations.

It was written by bureaucrats over many It was written by bureaucrats over many years, with the idea of pleasing everyone years, with the idea of pleasing everyone 100%.100%.

It was voted down by the French, and the It was voted down by the French, and the British are avoiding voting on it for now.British are avoiding voting on it for now.

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What’s the French Problem?What’s the French Problem? Voters may have just wanted to express to Voters may have just wanted to express to

President Jacques Chirac their displeasure with President Jacques Chirac their displeasure with their high unemployment rates and poor economy.their high unemployment rates and poor economy.

Some voters may be expressing a form of French Some voters may be expressing a form of French nationalism:nationalism: They are afraid that the “French economic way of life” is They are afraid that the “French economic way of life” is

being pushed aside by foreign interests.being pushed aside by foreign interests. The French have preferred short workweeks, long The French have preferred short workweeks, long

vacations, and emphasized quality of non-economic life vacations, and emphasized quality of non-economic life over income growth. over income growth.

They have a lot of socialistic tendencies, high levels of They have a lot of socialistic tendencies, high levels of transfers, rigid labor markets dominated by strong transfers, rigid labor markets dominated by strong centralized unions, etc.centralized unions, etc.

Has the economic integration ignored differences in Has the economic integration ignored differences in objectives among members?objectives among members?

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What about the Dutch?What about the Dutch?

Like the French, the Dutch are concerned Like the French, the Dutch are concerned about preserving their way of life. about preserving their way of life. The Dutch have a freewheeling, libertarian The Dutch have a freewheeling, libertarian

culture. They have legal euthanasia, culture. They have legal euthanasia, prostitution, and marijuana bars. prostitution, and marijuana bars.

Like the French, they may fear that the Like the French, they may fear that the admission of a large Muslim nation like Turkey admission of a large Muslim nation like Turkey will fuel the growth of Islamic fundamentalism will fuel the growth of Islamic fundamentalism among their large Muslim minority.among their large Muslim minority.

Neither the French nor the Dutch want to Neither the French nor the Dutch want to destroy the EU, they just don’t want to destroy the EU, they just don’t want to make it stronger.make it stronger.