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Outline of lectures – 5: October 30th
• Exchange rates monetary policy and the real economy
• Exchange rates • What drives them. Exchange rate policy?
• Monetary Regimes • Sterling union 1922-1972-1979
• EMS 1979-1998
• EMU
• Case of German unification and the European economy
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Assessment
• 20% for a presentation in class • First set of topics on 9th October, for individual presentations on 23rd & 30th
October
• Second set of topics - details later
• 40% take home exam • Issued 11th December due on 14th December
• 40% Assignment. • Submission by 17.00 on 22nd January
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Presentations
• November 20 Ragnar Almquist • What is money? Can it be clearly distinguished from other non money assets? Has financial innovation made
it impossible to control the money supply?
• November 27 Paul Lynam • John Law believed in what is now called ‘quantitative easing’. Richard Cantillon did not. What relevance, if any,
does this eighteenth century debate have for the analysis of modern monetary policy?
• December 4 Cathal McMorrow • Was the financial crisis, which started in 2007/8 in the United States, caused by a property market bubble?
• December 11 Ian Slattery • Friedman and Schwartz’s analysis of the monetary problems of the Great Depression showed the need for the
Federal Reserve Bank to use active monetary intervention during the recent financial crisis. John Maynard Keynes would have also recommended such action. Does this imply that that the gap between monetarists and Keynesians is a great deal less than that made out by many commentators?
• December 18 Eoghan Hanrahan • Compare and contrast the performances of the Federal Reserve Bank with the European Central Bank during
the recent financial crisis.
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The Nominal Exchange Rate
• Exchanging £ for € is like any other economic transaction where goods or services are bought and sold
• Normal laws of demand and supply apply
• The price you pay for the foreign currency is the nominal exchange rate
• Exchange rates change daily – variable rates • With the old Irish pound in the 18th c. – different exchange rates in Cork and
Dublin
• A depreciation of the Euro means it buys less of another currency
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The Real Exchange Rate
• Example:
• Real exchange rate=𝑆𝑡𝑒𝑟𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑𝑠
𝑆𝑡𝑒𝑟𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑𝑠
• If the real exchange rate appreciates: then losing competitiveness
• May use consumer prices or wages to measure competitiveness in this way
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The Law of One Price
• If price in Dublin is cheaper than Belfast • Someone could buy up the stock in Dublin and sell in Belfast at a profit • i.e. Arbitrage
• In the absence of barriers to trade arbitrage will produce price convergence • However, there are many barriers – e.g. transport costs
• Example of cross-border shopping • Major driver is companies competing
• Exchange rate a significant barrier • Changing prices is costly • Generally sell abroad in foreign currency. Changes in exchange rates change value in
own currency. Have to predict exchange rate – or hedge
• In practise the law of one price does not hold in short run • Not a very reliable guide in longer term either
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Purchasing Power Parity (PPP)
• In long run one would expect PPP to hold – but often does not
• In the case of Ireland, up to 1998 Irish prices were equal to the UK price with a lagged adjustment to exchange rate changes
• However, does not hold after EMU, at least in short run
• With Imported goods – why do prices differ from other countries?
• If all goods imported then: • Domestic prices=Import price* exchange rate • Domestic inflation rate = foreign inflation rate + % change in exchange rate • With price set in foreign currency prices would change every day • However, prices don’t change every day – who pays the difference?
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Relative Prices
2005 2014 2014 Food
EU28 100.0 100.0 100
EU15 105.9 107.1 107
Denmark 146.0 139.7 135.2
Germany 103.1 101.3 109.6
Ireland 124.5 124.5 113.5
Greece 87.2 83.0 98.9
Spain 90.7 92.4 93.8
France 109.0 107.2 108.4
Netherlands 105.6 112.5 97.4
United Kingdom 110.7 121.7 104.2
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Irish and UK Prices, common currency
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3.5
3.7
3.9
4.1
4.3
4.5
4.7
4.9
1979Q1 1981Q1 1983Q1 1985Q1 1987Q1 1989Q1 1991Q1 1993Q1 1995Q1 1997Q1
Irish UK
Purchasing Power Parity
• Price in Ireland = Price in UK * exchange rate
• If it holds it implies: • Irish inflation = UK inflation + change in exchange rate
• Irish inflation – UK inflation = change in exchange rate
• If PPP held then inflation rates would be identical across Euro area • In long run – not too far from PPP
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Average inflation rate 1998-2014
European Union 2.3
Euro area 1.9
Belgium 2.0
Germany 1.5
Ireland 2.3
Greece 2.6
Spain 2.6
France 1.5
Italy 2.1
Netherlands 2.1
Austria 2.0
Portugal 2.2 30/10/2015 12
Exchange Rates in the Short Run
• Increase in money supply – more credit • More credit - buy more imports, but no change in exports
• Demand for foreign exchange rises – to buy the foreign good • This causes the price of foreign currency to rise • Makes imports more expensive in domestic currency • Higher prices for imports in domestic currency – higher inflation
• Thus change in quantity of money affects inflation through exchange rate. • If demand rises for Euro goods but no increase in domestic demand or
imports by the Euro area. • Then Euro will rise. This will make imports cheaper for consumers • Of course it will also make exports more expensive for foreign buyers • Offsets, to some extent, the rise in foreign demand
• Hedging exchange rate risk
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Factors affecting exchange rates in short run
• A change in domestic money supply (or foreign money supply)
• Change in demand for imports
• Change in demand for exports
• Change in demand for domestic and foreign assets
• Change in interest rate differentials
• Change in expectations about exchange rates
• Government policy Central Bank exchange rate intervention
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Exchange rate intervention
• Central Banks can buy and sell foreign exchange • To smooth markets
• Hold reserves – to allow them to buy domestic assets held abroad • Sell Euros for dollars – drives up value of dollar • Sell dollars to buy euros– drives up Euro
• Attempt to permanently shift the exchange rate • Frowned upon today – e.g. rhetoric in US about China. Pegged at too competitive a rate • Essential in a fixed exchange rate regime • But is it sustainable?
• The EMS – an example • Agreement that partner Central Banks will buy unlimited quantity of domestic
currency at a fixed price. • Different in practise
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Exchange rate intervention
• ECB sells (buys) foreign assets (must have foreign assets – reserves)
• This drives up (down) the foreign currency
• However, if the ECB buys the asset from a domestic bank it increases domestic money supply
• Can sterilise the impact on the domestic money supply if it wishes by simultaneously selling a Euro bond.
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Objective of international investors
• Free movement of capital – greatly increases volatility • More efficient allocation of capital – but comes at a cost • Capital controls may help support an exchange rate.
• Objective of investors to maximise return on financial assets
• With fixed interest assets – bonds – the return depends on the interest rate and the expected change in the exchange rate.
• Risk premium may intervene
• If interest rate higher elsewhere and exchange rate expected constant • Then invest abroad. • The flow of investment will move the exchange rate
• The announcement by Draghi of QE moved the exchange rate immediately • Returns on € assets expected to be lower relative to US assets. The exchange rate movesd to
make the expected return on the two assets identical in medium term
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Monetary Policy Regimes
• Advantages of a fixed exchange rate regime: • Lower transactions costs – changing exchange rates for trade • Reduces risk on flows of capital – foreign investment – risk premia • Reduces risk on trade – setting prices ahead of trade in foreign currency • May enhance competition because of price transparency
• Disadvantages of a fixed exchange rate regime: • It imports foreign monetary policy – Ireland and the UK pre 1979 • Unable to change exchange rate to deal with shocks • Optimal currency area literature
• Argued sterling devaluation 2000 could have seriously hit Ireland – it actually appreciated • Possible country specific shocks could be costly with fixed exchange rate
• Recent experience - would adjustment have been less painful without EMU?
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Monetary Policy Regimes
• Costs of a fixed exchange regime minimised if prices flexible • If suffer a shock causing unemployment – how rapidly do wages adjust to
price an economy back into the market? • Adjust through wages, goods prices, migration etc. • Flexibility to deal with shocks through exchange rate or flexible prices
• EMU v Fixed exchange rate
• EMU permanent – don’t need to hold foreign exchange reserves to manage fixed rate
• EMU – much less danger of a speculative attack • “Attacks” on Ireland and Greece failed because unlimited resources deployed
by ECB
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Monetary Regimes: Irish Experience
• Bretton Woods – fixed £ - $ rate • 1967 devaluation of £. • Broke up in 1970s
• Sterling union • 1972 legal framework changed – did not change behaviour • No margins clearing
• EMS 1979 • Not a fixed link – a crawling peg • Risk and uncertainty
• EMU 1999
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The Sterling Regime
• No margins clearing
• PPP held
• Therefore, Bank of England controlled Irish inflation through controlling UK money supply
• Interest rates – could they differ? 1956 • Honohan http://www.jstor.org/stable/pdf/27724949.pdf?acceptTC=true
• Inflation in 1975-6 • The problem was Bank of England monetary policy • What to do about it?
• Risk and expectations
• Ended with EMS in January 1979
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Rate of Inflation in Ireland
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-5
0
5
10
15
20
25
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
PC_DOT
EMS
• European Monetary System • Initially viewed in Ireland as a fixed exchange rate regime
• On the face of it relatively fixed exchange rates • Partner Central Banks commit to intervene to maintain bilateral exchange rates
• In practise, a crawling peg.
• September 1992 – sterling drops out of EMS • September 1992- January 1993 speculative attack on Ir£ • September 1992- January 1993 very high interest rates • CBI was buying Ir£ with DMs – did it have enough? • January 1993 Ireland devalues
• Effectively Bundesbank set German monetary policy • Rest of EMS reacted to German policy • Led to a fairly “hard” regime
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Risk premium: percentage points
1980-98 1985-98
Ireland 2.0 1.6
Spain 1.4 1.9
UK 2.1
Relative to DM
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EMS
• Risk premium • Why not borrow in DMs? Exchange risk
• Ability to hedge the risk?
• Inflation • Consumer prices – UK prices + lagged adjustment to exchange rate change
• UK inflation, not German, was important
• PPP still held
• Currency in which contracts written – not IR£
• Growing financial integration over the EMS period • Free movement of capital
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German Unification 1990
• Monetary regime – the EMS • The German government promised Germans that unification would not
cost them. • The Bundesbank targeted inflation in Germany
• What was happening in other countries was irrelevant to them
• German government expanded Public Expenditure and borrowed • Raised German inflation • Bundesbank raised interest rate • This meant returns to investment higher in Germany • However, with EMS, other countries strove for fixed exchange rate • Consequence – Other countries had German interest rates
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EMS - Germany
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Interest Rate 8.4 9.2 9.5 7.2 5.3 4.5 3.3 3.3 3.5 3.0
Borrowing NA -2.8 -2.5 -3.0 -2.4 -9.3 -3.4 -2.8 -2.4 -1.5
Expenditure NA NA NA NA NA 54.6 48.8 48.0 47.6 47.6
Inflation 2.7 3.7 5.1 4.4 2.7 1.7 1.4 1.9 0.9 0.6
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EMS – German Unification
• Higher German interest rates meant returns to investment higher in Germany
• However, with EMS, other countries strove for fixed exchange rate
• Consequence – Other countries had German interest rates
• Inappropriate for rest of Europe – deflationary consequences
• Inflation Rates:
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1991 1992 1993 1994 1995
France 3.2 2.4 2.1 1.7 1.8
Germany 3.7 5.1 4.4 2.7 1.7
EMS – German Unification
• Applying German monetary policy to EMS countries deflationary
• Appropriate for Germany, inappropriate for rest of EU
• EMS choice of EMS members – could have devalued, eventually did
• Substantial reduction in GDP in rest of EU • Ray Barrell et al, 1996, Table 4, http://www.sciencedirect.com/science/article/pii/0264999396010218
• The effects were also significantly negative for Ireland • Bradley et al., 1991 ESRI Medium-Term Review http://www.esri.ie/pubs/MTR04.pdf pp. 25-27 & 51-52
• May have delayed the Celtic Tiger from 1990 to 1994
• Counter-factual: What would have been the effect on EU if there had been EMU?
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EMU
• Did bring convergence in interest rates – till 2008
• Risk intervened 2008-2014
• However, risk premia now quite low – back close to 2000 world
• However, PPP does not hold in SR – sustained differences in inflation rates.
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EMU – Monetary Policy Today
• ECB targets Euro area inflation
• Because inflation < 2% - zero interest rates and QE
• German economy is growing faster than potential • Putting upward pressure on wages and asset prices
• German concern that monetary policy is inappropriate for Germany
• Monetary policy is appropriate for Euro area as a whole.
• Consequence of EMU – fixed exchange rates
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Other examples
• Argentinian currency board in late 1990s – collapsed
• Dollarisation – Ecuador
• African Monetary union
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Questions
• Was Ireland right to join EMU?
• Was Germany right to join EMU?
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Presentations – 30th October
• Martin McDermott • Is the Irish financial system fit for purpose? What defects are there and how
should they be remedied?
• Fionnuala Finn • Should the Central Bank have imposed LTV and LTI limits? Are they needed?
Will the banks not act sensibly any way? What risks are these measures addressing?
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References
• Cecchetti and Schoenholtz, Money, Banking, and Financial Markets, Chapters 10 and 19
• Blanchard, Amighini and Giavazzi, Macro-Economics a European Perspective, Chapter 19.
• History of Irish pound http://www.jstor.org/stable/pdf/27724949.pdf?acceptTC=true
• Sterling link http://cepr.org/active/publications/discussion_papers/dp.php?dpno=1040#
• EMU – in advance: • http://www.esri.ie/pubs/PRS28.pdf Chapter 12 and summary
• Lars Calmfors ed., 1997, EMU – A Swedish Perspective. Not in TCD library?
• Emu – ex post: • World Economy, Fitzgerald http://onlinelibrary.wiley.com/doi/10.1111/1467-9701.00415/epdf
• Ireland and Spain http://ner.sagepub.com/content/211/1/91.full.pdf+html
• Honohan, 2006, http://www.tara.tcd.ie/handle/2262/60020
• German unification and the EMS • Ray Barrell et al, 1996, http://www.sciencedirect.com/science/article/pii/0264999396010218
• Bradley et al., 1991 ESRI Medium-Term Review http://www.esri.ie/pubs/MTR04.pdf pp. 25-27 and 51-52
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References
• On PPP • “Divergent Inflation Rates in EMU” (with Philip R. Lane), Economic Policy Vol.
18, Issue 37, October 2003, pp. 357-394.
• FitzGerald J., and F. Shortall, 1998, “Pricing to Market, Exchange Rate Changes and the Transmission of Inflation”, The Economic and Social Review, Vol. 29, No. 4
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