365 Topic7 - ECO365 Topic 7 The Choice of Exchange Rate...

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The Choice of Exchange Rate Regime and The Euro ECO365 Topic 7
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Overview 1. The Case of Britain and its peg 2. The determinants of an exchange rate regime 3. The theory of optimum currency areas 4. The conditions for joining Eurozone 5. Assessing the Euro 2 ECO365
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Timeline The choice of exchange rate regimes has evolved over the years …. . 3 ECO365
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Britain and Europe European Union (EU) countries moved toward a single currency in the 1980s and 1990s. Expectation that common currency in Europe would promote trade through lower transactions costs and also help to anchor inflation. They adopted exchange rate pegs relative to each other, the Exchange Rate Mechanism (ERM). Britain joined the ERM in 1990. 4 ECO365
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Britain and Europe In practice, ERM members were pegged to the German deutschmark (DM) since the Bundesbank (German Central Bank) had monetary autonomy and pursued anti-inflationary policies. The DM served as the base currency or center currency. In the analysis, we treat Britain as the home country and Germany as the foreign country. 5 ECO365
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Britain and Europe A Shock in Germany German reunification required significant public spending for social programs and modernizing infrastructure in East Germany. Fiscal expansion… led to a boom, creating inflationary pressure, and an increase in Germany’s interest rate. The Bundesbank responded… by cutting the money supply to stabilize output, further raising Germany’s interest rate. 6 ECO365
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Britain and Europe 7 ECO365
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Britain and Europe Increase in Germany’s interest rate ( i*) had two effects on ERM countries. IS curve shifts to the right Higher German interest rates leads to a depreciation of the home currency (at a given level of i), so TB rises, increasing external demand in the home country. LM curve shifts to the left To prevent depreciation against DM, interest rates elsewhere in the ERM must increase. Central banks must follow Germany’s lead, cutting the money supply and raising the nominal interest rate (with i=i*) to keep the exchange rate fixed. 8 ECO365
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Britain and Europe Choice for other ERM countries 9 ECO365
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Britain and Europe Choice 1 : Float and Prosper? Britain chooses to keep its interest rate unchanged. (Point 4) IS curve shifts to the right. LM curve shifts to the right. To keep the interest rate unchanged, the Bank of England would need to expand the money supply, shifting LM to the right. To keep the home interest rate unchanged, the new equilibrium is at point 4, where output increases and the pound depreciates relative to the DM. 10 ECO365
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Britain and Europe Choice 2 : Peg and Suffer? Britain remains on ERM (Point 2)
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365 Topic7 - ECO365 Topic 7 The Choice of Exchange Rate...

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