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					       Chapter 6:
The Fragility of Incomplete
    Monetary Unions

         De Grauwe:
  Economics of Monetary Union
      Incomplete monetary unions
• Incomplete monetary unions are arrangements
  whereby the monetary authorities peg their
  exchange rates
  – Examples: the Bretton-Woods system and the ERM
• Over time most of these arrangements tend to
  disintegrate after some crisis:
  – The Bretton-Woods system collapsed in 1973
  – The exchange rate mechanism (ERM) of the EMS
    collapsed in 1993
  – The South-East Asian currencies were hit by speculative
    attacks in 1997-98
  – Similar crises involved Latin American currencies in the
   Why are pegged exchange rate
       regimes to so fragile?
• The fragility of a fixed exchange rate system
  has everything to do with credibility
• When the authorities announce a fixed
  exchange rate they are making promise to keep
  the exchange rate fixed today and in the future
• The problem with any promise is that doubts
  may arise as to whether it will be kept
• Circumstances may arise in which the fixed
  exchange rate arrangement ceases to be seen
  as consistent with the economic welfare of the
• In that case the monetary authority will have
  an incentive to renege on its promise
• Economic agents will suspect this and will
  attack the currency
• A speculative crisis arises
 Differences in reputation lead to low
  credibility of a fixed exchange rate
• Barro - Gordon model is our framework for
  analysing problems of reputation
      Fixing exchange rate is not credible
           Germany                                   Italy
 pG                                     



 pG                      C                                       F

                                     UG                                   UI
Fixing the exchange rate of the lira with the mark is not credible, because
Italian authorities have an incentive to create surprise inflation
– In this model the high-inflation country (Italy) has a
  lot to gain from pegging its currency to the currency
  of the low-inflation country. It is borrowing
– Italy will find it difficult to fix its exchange rate
– The Italian authorities have an incentive to cheat (a
  temptation) so as to reduce unemployment
– This temptation is larger the steeper is the
  indifference curve (see previous figure), i.e. the
  greater the weight the authorities attach to
  stabilizing employment (or output), a domestic
– The weight the central bank attaches to this
  domestic objective is represented by 
   Relation between the temptation of the central
       bank to devalue and the parameter 
                          •Temptation, , = the benefit for the
temptation                authorities of devaluing, given that agents
                          expect that the central bank will never
                          renege on its promise.
                               •When >0 the central bank is tempted
                               to devalue
                               •This temptation increases with 
                          •This regime in which the central bank fixes
                          the exchange rate and then gives a non-
                          zero weight to a domestic objective will not
                          be credible
                          •Rational agents will test the central bank
                          and attack its stock of international reserves
                          •Since most central banks give some non-
                          zero weight to domestic objectives, fixing
                         the exchange rate will most of the time not
                          be credible (except if =0)
        Fixed exchange rates are credible if
            cost of devaluation is high
                                       •It is possible for the central
                      Figure 5.1       bank to combine fixed exchange
temptation                             rates and credibility only if
                                       devaluation is costly
                                       •The cost is a loss of reputation
                                       • By assumption this cost is fixed
                                       ( C0)
                                       •As long as < 0 the fixed
                                       exchange rate can be made
C0                                     credible, because the cost of
                                       loosing reputation exceeds the
                                       temptation to devalue
                                       •Will this hold in all states of
                 0                
             Temptation curve, , as a function
                of the size of the shock, .
                                    • is a shock in the Phillips curve
                                    •When >0 Phillips curve shifts
temptation                          upwards, creating unemployment
                                    •The temptation to devalue
                                    increases with the size of the shock
                                    (upward sloping), for any given 
                                    •As the shock becomes larger the
                                    cost in terms of lost employment (or
                                    output) increases increasing
                                    •When the shock is zero (=0)
                                    temptation is 1
                                    •If this is smaller than C0, the fixed
                                    exchange is credible
                       0          •When > 0 temptation exceeds cost
                                    of devaluation; fixed rate looses
         ‘First generation’ models
             (Krugman (1979))
• As time goes by, the probability that some
  shock will exceed 0 is positive
• A sufficiently large shock will make the fixed
  exchange rate non-credible
• Only if the central bank can make it clear that
  it does not pursue any domestic objectives
  (=0) can this problem be avoided
• Thus a crisis is inevitable if the central bank
  pursues domestic objectives that conflict with
  exchange rate commitment
      ‘Second generation’ models
           (Obstfeld (1995))
• This model stresses that a country that
  attaches a low weight to domestic objectives
  and thus has a credible fixed exchange rate
  can still get into trouble
• Assume that for some reason speculators
  expect the currency to be devalued
• The authorities who want to maintain the fixed
  exchange rate will have to defend it against
  these speculators
• Such a defence is costly
• The central bank will be tempted to abandon
  the peg
 – We derive a second temptation curve ()
 – This is the temptation to devalue when the authorities face
   expectations that a devaluation will occur
 –  increases with , i.e. the more the authorities care about
   domestic objectives the greater is the cost of defence and
   thus temptation


• Temptation curve  is located above the
  temptation curve 
• This is due to an asymmetry
• The welfare loss from applying deflationary
  policies to defend the peg in the face of a
  speculative attack is greater than the welfare
  gain obtained from the expansionary
  employment effects of surprise devaluation
                                   Assume =1
                                   There are two possible
Cost of defence
                                   A) Speculators do not expect a
                                   •The temptation of the central
                                   bank to devalue, , is lower
                           Θ       than the cost of a devaluation
                                   •The central bank has no
                                   incentive to devalue
                                   B) Speculators expect a
   C0                              • The relevant temptation
                                   curve is 
                                   •The temptation to devalue is
                                   larger than the cost of a
                               β   •The central bank has an
                                   incentive to devalue
• There are therefore two possible equilibria that
  depend solely on the state of expectations
  – When agents do not expect a devaluation the
    authorities have no incentive to devalue so that the
    exchange rate remains fixed
  – When speculators expect a devaluation, the
    ensuing speculative attack creates an incentive for
    the authorities to devalue, and there will be a
  – In both cases expectations are model-consistent
Temptation,                                                            •Whether or not crises occur
  Cost of defence
                                                                       depends on combinations of 
                                                                       and C
                                                        
                                                                       •Three situations can occur:
                                         indeterminacy zone                –When  is low and C is
                                                                           high, we are in the no
                    no attack zone                            attack zone
                                                                           attack zone
                                                                           –When  is high and C is
                                                                           low we are in the attack
                                                                           –There is an intermediate
                                                                           zone (indeterminacy zone)
                                                                           where the cost of
                                                                           devaluation is intermediate
                                                                           between the two
                                                                           temptation curves
          Policy Issue arising from greater
                   capital mobility
 Temptation,                       •When capital mobility increases:
Cost of defence                    •the temptation curve  shifts
                                   upwards (from  to ’)
                                   •Indeterminacy zone increases
                  Δ’               •Fixed exchange rate becomes more
                           Θ       •Choice between more flexibility or
                                   tighter discipline on fixed rates
  C1                               •To keep the economy within the no
                                   attack zone:
                                   1)Increase the cost of devaluation
                                   from C0 to C1
                                   Example: Maastricht fixed exchange
                                   rate condition as entry requirement
                                   for EMU
                               β   2) Reduce the weight for domestic
The n-1 problem in pegged exchange
            rate systems
• In a system of n countries, there are only n - 1
  independent exchange rates
• Implications
   – n - 1 monetary authorities have to adjust their
     monetary policy instrument so as to maintain a
     fixed exchange rate
   – One monetary authority is free to set its monetary
     policy independently
   – Who will be the central bank that uses this degree
     of freedom?
   – Potential for conflict
       Two-country model of the
           money markets
• Country A
  – money demand: MAD = PALA( YA , rA)
  – money supply: MSA = RA+ DA
     • PA price level of country A, YA output, rA, interest rate , RA
       international reserves, DA credit to the domestic sector
• Country B
  – money demand: MBD = PBLB( YB , rB)
  – money supply: MSB = RB+ DB
• We assume perfect mobility of capital
• The (open) interest parity condition holds
   – rA = rB + 
     •  is the expected rate of depreciation of the currency of
       country A.
• In a fully credible fixed exchange rate system:
  = 0.
       The n-1 problem in a two-country
               monetary model
  rA                                     rB
           Country A                                       Country B

            G                                          H

                             E                                     F


          M2A          M1A          MA           M2B            M1B    MB
•money demand downward-sloping curves
•money supply M1A M1B
•money market equilibrium where demand and supply intersect (points E and F).
•the interest parity condition holds
• Infinitely many combinations will satisfy the
  equilibrium conditions
• Each of these combinations will produce one
  level of the interest rate and one of the money
• The fixed exchange rate arrangement is
  compatible with any possible level of the
  interest rates and of the money stocks
• There is a fundamental indeterminacy in this
      How can the indeterminacy
             be solved?
• Two possible solutions:
  – The asymmetric (hegemonic) solution
     • One country to take a leadership role by anchoring the
       money stock for the entire system
     • Example: Country A is leader and chooses point G; then
       country B has to take point H
  – The symmetric (co-operative) solution
     • Countries decide jointly about the level of their money
       stocks and interest rates
• The mechanics of interventions in the foreign
  exchange market are different in the
  symmetric and asymmetric system
• We illustrate this when a speculative crisis
                      Intervention in a
                     symmetric system
                                                     •Currency B is expected to
                                                     •Speculators sell currency B
      Country A                         Country B    against currency A
 rA                          rB                      •Central bank B buys its own
                                                     currency and sells currency
                                                     •Country B’s money stock
                                  r3                 declines and country A’s
                                  r’2                money stock increases


                                          M3B       M1B

           M1A M2A      MA                   M2B                   M
         Asymmetric intervention
• Country B does all the adjustment
  – Money stock declines to M3B
  – Interest rate increases to r3
• Country A keeps money stock and interest
  rate unchanged (using sterilization policies)
• The Bretton-Woods system and the EMS
  were asymmetric
  – When a speculative crisis arose, the leading-
    currency country (the US in the Bretton Woods
    system, Germany in the EMS) was generally
    unwilling to allow its money stock to increase and
    its interest rate to decline
Symmetric and asymmetric systems
• Advantages of the asymmetric system
  – Discipline on the peripheral country
• Disadvantages of the asymmetric system
  – The business cycles in the peripheral country are
    likely to be made more intense by the pro-cyclical
    movements of the money stock of the periphery
 Disadvantage of asymmetric system:
       recession in periphery
        Centre country                     Peripheral Country


                  M1A           MA                      M1B          MB

Money demand in periphery declines; since centre country keeps interest rate
fixed, money supply in periphery must decline; monetary policy is pro-cyclical,
aggravating the recession; total money stock in system declines
 A recession in the peripheral country
        in a symmetric system
rA       Centre country                    rB         Peripheral

                M1A   M2A    MA                      M2B    M1B         MB

     In this system central banks cooperate; peripheral country reduces its
     money stock while centre country increases it; total money stock in
     system is unchanged
• Incomplete monetary unions often lack
  credibility and are often hit by a speculative
• Increasing capital mobility increases the fragility
  of fixed exchange rate regimes
• This has put many countries in the
  uncomfortable dilemma that they have to
  choose between either more exchange rate
  flexibility or a monetary union
• Fixing exchange rates in Europe can only work
  as a transitory device towards full monetary