The management of the

exchange rate in Europe

CNAM- INTERNATIONAL INSTITUTE OF MANAGEMENT
AND INSTITUTUL NATIONAL DE DEZVOLTARE ECONOMICA (INDE)
(Academiei de Studii Economice din Bucurestu)
BUCHAREST, October 2013, 25 and 26
Jacques ISSOULIE
Banque de France
Definition of the exchange rate

Nominal echange rate

Real exchange rate

Movements in the nominal and real exchanges rates

The exchange rate in the long run: the purchasing power parity

Relative or absolute PPP

Other determinants of the exchange rate in the long run

The interest parity condition
Exchange rate regimes

Floating rates

Fixed exchange rates

The impossible trinity principle

Monetary integration

The snake

The European monetary system
The convergence criteria

Optimum currency areas theory

18 members of the eurozone

The euro crisis
WHAT IS THE EXCHANGE RATE ?
The nominal exchange rate ?
Exchange rates can be quoted in two ways.

In British terms , you get the number of foreign currency
units per domestic unit, that is to say, for example, USD 1,5
per EUR 1.

In European terms , you get the number of domestic
currency units needed to buy one unit of foreign currency, for
example, in the case of Switzerland, we have CHF 1,6 per
EUR 1.
Nominal exchange rate
If we adopt the British terms convention, an
appreciation of a currency corresponds to an
increase in its value in terms of foreign currencies ,
so that the exchange rate rises.

Conversely, a loss of value, or depreciation, implies a
decline in the echange rate.
The real exchange rate ?


Nominal exchange rates compare the relative prices of different
currencies but they dont say anything about how much one
can buy with each currency.

Prices in two different countries cannot be compared directly
since they are expressed in different currencies. Before any
comparison, we must convert prices into the same currency.
Real exchange rate
Real exchanges rates normally compare broad price indices such as the
CPI.

The real exchange rate is the ratio of the average prices of baskets
of goods in two different prices.

The real exchange rate = S P/P*

With S = nominal exchange rate, P the price index in the first country
and P* the price index in the second country
Movements in nominal and real exchange rates
The rate of change of the real exchange rate)

= rate of change of the nominal exchange rate + domestic inflation rate
foreign inflation rate.

The real exchange rate is driven by the nominal exchange rate and
the inflation differential .
Movements in nominal and real exchange rates

Exchange rate appreciation = foreign inflation rate domestic inflation
rate.

If inflation is durably lower than abroad, our currency should
appreciate in the long run.

A country with higher inflation sees its exchange rate depreciate
vis--vis the currency with a lower inflation rate.

Movements in nominal and real exchange rates

Since inflation differentials reflect differences in money growth, the
evolution of the nominal exchange rate is driven by relative money
growth rates.


In the short run, there is no visible link between the exchange rate , money
growth and inflation (the nominal exchange rate is very volatile, even
more than the money stock, while price differentials are much more
stable).


Movements in nominal and real exchange rates
A real appreciation is a loss of competitiveness, as goods become
expensive relative to foreign goods.

This happens when the nominal exchange rate appreciates or when
domestic inflation exceeds foreign inflation.
Measuring the real exchange rate ?
A country usually has several commercial partners.

We often calculate an average exchange rate and an average foreign
price level using weights that reflect the relative importance of the
partner.

The external terms of trade is the ratio of domestically produced
exports to foreign produced import prices.

The internal terms of trade is the ratio of non traded to traded goods
prices.

You may also compare the prices of labour.

The exchange rate in the long run: purchasing power parity
The PPP principle means that the real exchange rate is constant over
the long run.

The relative PPP is a natural implication of money neutrality. As
nominal variables, the nominal exchange rate and the price level are
not expected to durably affect real variables, including the real
exchange rate.
The relative PPP
This is a manifestation of the dichotomy principle. In the long
run, the domestic money supply proportionally affects
domestic prices the same holds abroad but not the real
exchange rate.

The relative PPP
The logic is simple. Suppose that monetary policy is more expansionary at home
than abroad. With money growing faster, we expect inflation eventually to be
higher at home.

If the nominal exchange rate remains unchanged, the real exchange rate
appreciates. This means that domestic goods and services become expansive
relative to foreign goods and services.

As a result, domestic producers gradually lose competitiveness.

Because of the increase in prices, the nominal exchange rate will depreciate and
this will tend to restore competitiveness.

If it depreciates by the full amount of the accumulated inflation differential, the
loss of competitiveness is entirely erased.

Thus, up to a certain extent, the PPP asserts that in the long run, a country
must retain its competiveness.
The absolute PPP
The law of one price posits that the same good should trade
everywhere at the same price when prices are expressed in the same
currency.

If prices were differents, arbitrages would take place until prices get
equalized.

That prices of the same goods are the same in different countries leads
to the absolute PPP principle.

Absolute PPP requires not only that the real exchange rate be constant
but that it be equal to unity.
What to think of PPP ?
Relative PPP appears as a pretty good rule of thumb.

Absolute PPP is rather not respected.
Other determinants of the exchange rate IN THE LONG RUN.
The real exchange rate is related to the primary account surplus: the
current account deteriorates when the real exchange
appreciates.

A reminder: the current account shows the net amount a country is
earning if it is in surplus, or spending if it is in deficit.
It is the sum of the balance of trade (net earnings on exports net
earnings on imports), factor income (earnings on foreign investments
payments made to foreign investors) and cash transfers.
The capital account records the net change in ownership of foreign
assets.
BOP = current account capital account + or balancing items
(statistical errors).

The short run and the long run exchange rates
The short run view is linked to financial markets, to the
exchange rate market.

The long run view is linked to the relative price of goods view .

The current nominal exchange rate is linked to the expected
future exchange rate.

As regards the future, a good bet is that (in the long run) the
relative price of goods view will prevail.
The interest parity condition

IRP: returns on similar assets cannot differ systematically across
countries when there is free trade in financial assets, when
financial capital is perfectly mobile.

Financial traders constantly scan the whole world and can instantly
move huge amounts of money at virtually no cost.

As a result, the IRP is satisfied virtually always and any deviation is
immediately corrected.

IRP does not hold in presence of capital restrictions.
The open economy and the interest rate parity condition

When the domestic interest rate is low relative to interest rates
elsewhere in the world, international investors are likely to borrow at
home to lend abroad.

That will result in outflows of capital and sales of the domestic
currency.

It will lead to a depreciation of the nominal exchange rate.

The central bank must decide what it wants to do.

The importance of flows often makes the situation unsustainable.

The domestic interest rate will have to move to the world level.






































stors are likely to borrow at home and use the proceedings to lend abroad.
The interest rates in different countries are closer the less the exchange
rate diverges.

Borrowing at home and investing abroad means initially converting the
borrowed amounts into the foreign currency and moving funds in
the opposite direction when the arrangements mature.

If in the meantime the domestic currency appreciates, the value of the
foreign invesment will decline (capital loss).

International financial markets are in equilibrium when capital flows of
this kind are unnecessary because the returns on domestic and
foreign assets equalized.

This property of international financial markets is called the interest
rate parity condition.

It can be stated as domestic interest rate = foreign interest rate +
expected exchange rate depreciation.

Foreign interest rate + expected exchange rate depreciation = return on
foreign assets.

Interest rate parity links the domestic interest rate to foreign
returns, the latter including capital gains or losses
Exchange rate regimes
We distinguish fixed (and adjustable) or fully flexible (or free float).

When they are freely floating, exchange rates are continuously
priced on foreign exchange markets.

Central banks intervene through selling or buying their own currency
against other currencies.

When it adopts a fixed exchange rate regime, a central bank
commits to keep the exchange rate within a declared band of
fluctutation.

If the currency weakens, the central bank buys it back, selling some of
its foreign exchange reserves.
Freely floating rates
If the currency strengthens, the central bank sells it and
accumulates more foreign exchange reserves.

If the domestic interest rate is below the foreign rate, this
triggers capital outflows and sales of the domestic currency.

The exchange rate depreciates.

If we suppose that prices are constant, a nominal depreciation
translates into a real depreciation which makes our goods
and service more competitive.
This results in an increase in exports.

This results in an increase in GDP/national income.

The movement stops when the interest rate is again equal to the
foreign rate

An increase in the money supply will decrease the interest rate
and thus affects the exhange rate and competitiveness (that
is why monetary policy works)
The case for flexible exchange rates
When shocks occur (national or international recessions, oil shocks,
technological change) prices must be adjusted to avoid deepening
cyclical fluctuations. When prices and wages are sticky, the required
adjustment may take far too long. Flexible rates provide the fast way
to adjust relative domestic and foreign costs and prices.

Exchange rates and politics: an appreciation or a depreciation affects
income distribution (appeciation = consumers find imported goods
cheaper but exporters must compress profit margins and maybe
labour costs to remain competitive) (depreciation = it hurts the
consumer and benefits the producers) and is perceived as a
judgement on the governments competence. Depreciation = failure.
Removing the exchange rate from the political field is desirable.

Difficulty to renounce the convenience of MP autonomy.
Fixed exchange rate
Money supply increases > the interest rate decreases > capital
outflows and sales of the currency > exchange rate
depreciation.

But, the central bank does not let the exchange rate depreciate.

It sells its reserves, buying the currency back.

It re-absorbs sole of the money it has created > the money
supply shrinks.
The interest rate starts increasing again.

In practice, exchange rates are rarely rigidly fixed and are
usually allowed to move within bands.

According to the width of the band, the room for monetary
independance is more or less extended.

For small economies, the price level is determined by the foreign
price level.
The case for fixed exchange rates
Tendency of exchange markets to misbehave + Cases where
exchange rate policy is useful.
Exchange markets = short-term financial logic + information
about the future: essential but highly imperfect. Fads,
rumours and herd behaviour > panics
Market gyrations provoke at least large fluctutations >
uncertainty > curb trafe and foreign investment
Harnessing MP to an exchange rate target introduces discipline
since markets sanction inflationary policies
In case of serious shocks, parity realignments are always
possible ( fixed but adjustable ). Adopting a parity is not a
permanent commitment but rather an anchor for MP.
The impossible trinity principle
In a fixed exchange rate regime, monetary policy is lost as an
autonomous instrument of economic policy while it is fully
available when the exchange rate is floating.

Choosing an exchange rate regime is choosing a monetary policy
(autonomous or not).

When a country forms a monetary union with other countries, it
loses monetary policy as an instrument of monetary policy.

More precisely, the loss that matters is the short run loss since,
in the long run, monetary policy is neutral.

The true implication is that the inflation rate is no longer
established by domestic authorities (this may be desirable for
inflation-prone countries).

One way of escaping choosing between exchange rate stability
and monetary policy autonomy is to restrict capital
movements.

Many European countries operated capital controls until the
early 1990s when full capital mobility was made compulsory.

Many of the new members only abandoned controls upon
accession.
The logic of monetary integration
Only two of the three following features can
be simultaneously in place:
- full capital mobility
- autonomous monetary policy
- fixed exchange rates.
Full capital mobility and autonomous monetary policy: MP is
effective but the central bank cannot control the exchange
rate (Eurozone and US).

Full capital mobility and fixed exchange rate: loss of MP and the
central bank dedicates itself to upholding the fixed exchange
rate commitment, maybe by exploiting the limited room for
manuvre made possible by a margin of fluctuation (current
ERM members).

Fixed exchange rate and monetary policy autonomy: capital
controls block the interest parity principle. This combination
was widespread under the Bretton Woods system. Most
developing countries followow this strategy.
Snake in the tunnel
The Basle agreement in 1972 (10 April 1972) between the six
existing EEC members and three about to join (the pound
sterling, the Irish punt and the Danish crown) established a
snake in the tunnel.

Bilateral margins between currencies limited to 2,25% implying a
maximum change between any two currencies of 4,5%.

The tunnel collapsed in 1973 when the USD floated freely.

The snake proved unsustainable.

In 1977, it had become a DM zone with the Belgian and Luxembourg
franc, the Dutch guilder and the Danish krone.
The European Monetary system
In March 1979, the EMS replaced the European Currency snake.

Elements of the arrangement:

- The ECU: a basket of currencies preventing movements above 2,25%
around parity in bilateral exchange rates with other member countries.
- An Exchange Rate Mechanism (ERM).
- An extension of European credit facilities.
- The European Monetary Cooperation Fund (allocates ECUs to member
central banks in exchange for gold and USD deposits).

Several crisis: 1986, 1992

The monetary union
The MAASTRICHT TREATY (adopted on 10 December 1991).

Stage 1 (1990): full liberalisation of capital movements.

Stage 2 (1994): creation of the EMI, forerunner of the ECB.

Stage 3 (1997): launch of the monetary union and introduction of the euro.
The EMU and the euro
The EMS was replaced by the ERM 2 on 1 january 1999.

The ECU basket was discarded and replaced by the euro.

The ERM 2 is a waiting room for joining the EMU.

In the EMU the currencies of member states are replaced by the euro.
Convergence criteria (art 121 (1) of the EC treaty)
Price stability. The achievement of a high degree of price
stabilitywill be apparent from a rate of inflation which is
close to that of, at most, the three best-performing member
states in terms of price stability .
In practice, the inflation rate of a given member state must not
exceed by more than 1,5% that of the three best-performing
member states in terms of price stability during the year
prededing the examination of the situation in that member
state.
Government finances. The sustainability of the governement
financial positionwill be apparent from having achieved a
government budgetary position without a deficit that is
excessive . In practice, 2 crieria:

- the annual government deficit. The ratio of the annual
governement deficit to GDP must not exceed 3% at the end of
the preceding year.

- government debt. The ratio of gross government debt to GDP
must not excced 60% at the end of the preceding financial
year.
Exchange rates. The member state must have participated in
the ERM 2 without any break during the two years preceding
the examination of the situation and without severe tensions.

In addition, it must not have devaluated its currency (the
bilateral central rate for its currency against any other
member states currency) on its own initiative during the
same period.
Long-term interest rates. In practice, the nominal long-term
interest rate must not exceed by mote than 2% that of, at
most, the three best-performing member states in terms of
price stability. The period taken into consideration in the year
preceding the examination of the situation.
Optimum currency areas theory
A systematic way of trying to decide whether it makes sense for a
goupe of countries to abandon their national currencies.

The real economic cost of giving up the exchange rate instrument
arises in the presence of asymmetric shocks ie shocks that do
not affect all currency union members.

MUNDELL CRITERION (Robert A. Mundell)

Labour mobility : OCA are those within which people move
easily.

Factors of production, capital and labour, must be fully mobile
across borders.
Ex: country A undergoes unemployment while B faces
inflationary pressures; both problems can be solved by a shift
of idle production factors in A to B.

Europe is far from fulfilling this criterion.

KENEN CRITERION (Peter Kenen)

Product diversification: countries whose production and exports
are widely diversified and of a similar structure form an OCA.

The countries most likely to be affected by severe shocks are those that
specialize in the production of a narrow range of goods.

As far as this criterion is concerned, most EU countries qualify for
joining a monetary union.

Mc KINNON CRITERION (Ronald Mc Kinon)

Openness: countries which are very open to trade and trade
heavily with each other form an OCA.

Very open and medium size or little countries have no influence
on world prices. Giving up the exchange rate does not entail
much of a loss.

Europe qualifies.

TRANSFER CRITERION

Countries that agree to compensate each other for adverse
shocks form an OCA.

Fiscal transfers of this kind exist across regions in every
country. Some federal countries operate explicit transfer
systems.

Europe does not qualify yet.
HOMOGENEITY OF PREFERENCES CRITERION

Currency union member countries must share a wide
consensus on the way to deal with shocks.

Are we more concerned about inflation or unemployment?
Should we favour the exporters or the consumers ?
Unions, lobbiesPolitical consensus necessary.

This criterion is only partly fulfilled.

SOLIDARITY CRITERION vs.nationalism

When the common monetary policy gives rise to conflicts of national
interests, the countries that form a currency area need to accept
the costs in the name of a common destiny.

Europe qualifies partly.



Will europe come closer to an OCA ?
Asymmetric shocks ? Do asymmetric shocks happen often enough,
and are large enough, to be a serious concern ?

Openness (share of economic activity devoted to international trade? In
a small open economy, most of the goods produced and consumed
are traded on international markets. Their prices on local markets
are largely independent of local conditions. Any change in the value
of the currency tends to be passed into domestic prices. Exchange
rate changes fail to affect the countrys competitiveness and are
useless. Most European countries are very open, the more so the
smaller they are. They are in favour of the monetary union.

Diversification and trade dissimilarity ? Asymmetric shocks are less
likely among countries that share similar production patterns and
whose trade is diversified. Countries the economy of which is far too
integrated to afford exchange rate fluctuations whish to be deeply
involved in European integration.

Labour mobility ? Less evident than in the US or Canada.
Asymmetric shocks, when they occur, are likely to be met by
unemployement in countries facing a loss of competitiveness.
Fiscal transfers ? Definitely not an OCA!

Homogeneous preferences ? There remains some
heterogeneity. One reason why the inflation-prone countries
have been eager to join the monetary union is that it provides
for a degree of monetary policy discipline that has been
elusive in the past.

Solidarity vs nationalism ? We progress.
Will europe become an OCA ?
Effects of a currency union on trade ? Stable exchanges rates
promote trade integration which enhances fulfiment of the
McKinnon criterion.
Effects of trade on specialization/diversification?
- trade leads to more specialization as each country focuses on
its comparative advantage.
- trade leads to more diversification. Integration leads to intra-
industry trade: exports and imports include similar goods.
Every country produces the whole range of goods, simply with
different brands, offering customers more choice. In the
process, trade becomes more diversified.

Effects of a currency union on labour markets ? European
labour mobility is low. Flexibility is an alternative ?

Fiscal transfers ? No political support.

Politics ?
18 Members of the eurozone
1999: 11 MEMBERS:
AUSTRIA, BELGIUM, FINLAND, FRANCE, GERMANY, IRELAND, ITALY,
LUXEMBOURG, NETHERLANDS, PORTUGAL, SPAIN
2001: GREECE
2007: SLOVENIA
2008: CYPRUS, MALTA
2009: SLOVAKIA
2011: ESTONIA
2012: LETTONIA
MEMBERS OF THE EU NOT USING THE EURO
10 MEMBER STATES: BULGARIA, THE CZECH REPUBLIC,
DENMARK, HUNGARY, LATVIA, LITHUANIA, POLAND,
ROMANIA, SWEDEN, UNITED KINGDOM.

OPT-OUT CLAUSE IN THE TREATY FOR DENMARK AND UK.

SWEDEN: DE FACTO OPT- OUT (HAS NOT JOINED THE ERM2).

THE EURO CRISIS .


The reasons of the crisis ?

The elements of a solution ?