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Macroeconomic Policies in the EU Course given by Kiril Strahilov, PhD at MGIMO, Russia 7-10 October 2006

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Title: Macroeconomic Policies in the EU Course given by Kiril Strahilov, PhD at MGIMO, Russia 7-10 October 2006


1
Macroeconomic Policies in the EU Course given by
Kiril Strahilov, PhD at MGIMO, Russia 7-10
October 2006
2
Course Outline
1. European Macroeconomic Policies 1.1. Brief
Revision of European Monetary Integration 1.2.
Recent Macroeconomic Developments in the Euro
Area 1.3. Macroeconomic Policy Settings 1.4. The
External Dimension. 2. The Euro Area as an
Optimum Currency Area (OCA) 2.1. Benefits of
OCAs 2.2. Costs of OCAs 2.3. Costs and Benefits
compared 3. Monetary and Fiscal Policies in the
Euro Area. 9) 3.1. Institutional Aspects of the
ECB Credibility, Accountability and
Independence. 3.2. The Transmission Mechanism of
Monetary Policy 3.3.The Reform of the Stability
and Growth Pact 4. The Euro Area Enlargement
The Road of the Ten new EU Members towards
EMU 5. European Unemployment Basic Facts 5.1.
The Initial Rise of Unemployment the Role of
Shocks 5.2. Continuing Unemployment Sources of
Persistence 5.3. High Unemployment the Role of
Institutions
3
Bibliography
  • Blanchard, O. (2006). European Unemployment.
    Economic Policy Journal, pp. 7-59.
  • De Grauwe, Paul (2006). Economics of Monetary
    Union. 6th edition. Oxford University Press,
    Oxford
  • European Central Bank (2004). The Monetary Poly
    of the ECB. ECB, Frankfurt.
  • European Commission (2006). Annual Report on the
    Euro Area 2006. Directorate General for
    Economic and Financial Affairs.
  • Schadler, S. et al (2005). Adopting the Euro in
    Central and Eastern Europe. Challenges of the
    Next Step in European Integration. IMF Occasional
    Paper 234.
  • Zestos, George K. (2006). European Monetary
    Integration. The Euro. Thomson south-Western,
    London

4
1. European Macroeconomic Policies
  • 1.1. Brief Revision of European Monetary
    Integration

5
Bretton Woods Regime (fixed exchange rates)
  • Stable exchange rates, but adjustable
  • US dollar fixed in terms of gold (35 an ounce)
  • fixed parity for other currencies in terms of
    dollar
  • band around dollar parity plus or minus 1.0
  • adjustment of parities after consultation with
    the IMF
  • adjustments discouraged, allowed in case of
    serious balance of payments disequilibria,
    postponed by IMF loans
  • Central Banks of member countries hold reserves
    in gold or dollars
  • and have right to sell dollars for gold to
    Federal Reserve

6
Bretton Woods Regime (fixed exchange rates)
  • Consequences
  • dollar becomes the international currency
    (international dollar standard or gold exchange
    standard)
  • dollar takes on role of reserve currency
    (interest bearing)
  • Central Banks must intervene in foreign exchange
    markets to stabilise the exchange rate of their
    currencies by buying and selling dollars

7
Problems of B-W regime
  • Problem 1 Nth Currency Problem
  • two currencies means one exchange rate
  • (N currencies mean N-1 independent exchange
    rates)
  • both countries cannot independently fix the
    exchange rate.
  • EITHER both co-operate (symmetric solution)
  • OR one follows a policy of benign neglect
    (asymmetric solution). Role played by the USA
  • Problem 2 Realignments
  • definition changing the exchange value of a
    currency.
  • rendered difficult by the rules of the regime
  • postponed as much as possible.
  • Result

8
Problems of B-W regime
  • Problem 3 Speculative attacks
  • Exchange rate value loses credible
  • Massive sales (normally) or purchases of the
    currency.
  • Breakdown of Bretton-Woods regime
  • Inflation rises in the United States of America
  • accelerates because of expansionary fiscal and
    monetary policies (Vietnam war)
  • Two effects
  • Purchasing power value of US falls
  • Other countries import American inflation. (see
    further)
  • Markets start selling dollars in large quantities
  • Movement started by request of the Banque de
    France (de Gaulle) to USA to convert its dollar
    holdings into gold (exorbitant privilege).

9
Problems of B-W regime
  • Breakdown of Bretton-Woods regime (contd)
  • August 15th 1971. Nixon closes gold window
  • December 1971. Smithsonian Agreement general
    realignment and increase of band to plus or minus
    2.25
  • March 1973 free floating
  • Strong fluctuations of European currencies
    against the dollar and, therefore, even
    stronger fluctuations between the European
    currencies
  • 1976 Jamaica Agreements (official end to
    Bretton-Woods period)
  • In this context, the European Monetary System
    (EMS) is born.

10
First Steps Towards European Monetary Integration
  • Establishment of the European Payments Union
    (EPU) with effect from July 1950.
  • Principal purpose of EPU facilitate payments for
    trade in goods between the OEEC member countries
    in a world where currency convertibility was
    still an issue.
  • The EPU was a clearing union that replaced the
    existing agreements by a multilateral settlement
    and credit mechanism
  • bilateral claims and liabilities for each country
    were consolidated on a monthly basis in a single
    net position which defined the balance of
    payments situation of the country vis-à-vis the
    rest of the EPU countries.

11
First Steps Towards European Monetary Integration
  • Settlements could occur by payment in gold or
    dollars, or by automatic credit limited by
    quotas.
  • EPU set up to allow OEEC countries to liberalise
    trade in goods during the transition to currency
    convertibility.
  • Eichengreen (1993) immediate introduction of
    currency convertibility would have required large
    devaluations in addition to the currency
    realignments of 1949 and a consequent immediate
    loss in real income. Introduction of EPU avoided
    this, and gave member countries the time to
    redeploy their economies before rendering their
    currencies fully convertible. Without the EPU,
    multilateral trade in goods would have been
    endangered.

12
First Steps Towards European Monetary Integration
  • The Shuman Declaration of May, 9th 1950
  • The Treaty of Paris signed in April 1951
    established the European Coal and Steel Community
    (ECSC)
  • Common market for the two commodities,
    eliminating tariffs and quotas between the six
    member states

13
First Steps Towards European Monetary Integration
  • Messina Conference (Sicily) in June 1955
    possibility of establishing a Customs Union was
    studied
  • On March 25th 1957 two more treaties were signed
    European Economic Community (EEC) and the
    European Atomic Energy Community (EURATOM)

14
First Steps Towards European Monetary Integration
  • On 1 January 1958, the Treaty creating the
    European Economic Community (EEC) took effect.
  • Monetary matters were one of the least concerns
    in the Treaty. Exchange rate policies came under
    the jurisdiction of the International Monetary
    Fund (IMF).
  • The Treaty did require that the Member States of
    the newly formed EEC follow economic policies
    which were compatible with the Brettton-Woods
    commitments - currency convertibility, -
    stable nominal exchange rates, and -
    liberalisation of capital markets to the
    extent necessary to ensure the proper
    functioning of the common market (Article
    67, EEC)

15
First Steps Towards European Monetary Integration
  • and with fundamental economic policy objectives
    (balance of payments equilibrium, high level of
    employment and a stable level of prices).
  • The Treaty also required of the Council of
    Ministers of the Member States that they ensure
    the coordination of the general economic policies
    of the Member States (Article 145).
  • The general rules regarding economic and monetary
    policies were laid down in Articles 104 to 109
    and for the liberalisation of capital movements
    in Articles 67-73.
  • A Monetary Committee was created with a purely
    advisory role.

16
First Steps Towards European Monetary Integration
  • One event in this period is telling the German
    revaluation of 1961, but its lessons were not
    learnt when the Maastricht revision of the Treaty
    was undertaken.
  • Germany was subject to inflationary pressures
    both on account of a high level of domestic
    demand and large surpluses in the balance of
    payments current account.
  • A restrictive monetary policy on its own would
    have led, and did lead, to an increase in capital
    inflows and in inflationary pressures.
  • It also resulted in an excessive squeeze on
    domestic demand.
  • A revaluation of the currency was not encouraged
    by the IMF nor by certain domestic authorities.
  • The German central bank, the Bundesbank, did not
    have the authority to revalue the currency which
    was a competence of the Federal Government.

17
First Steps Towards European Monetary Integration
  • In the end, the Bundesbank was obliged to stop
    its restrictive monetary policies,
  • and a revaluation of the Deutsche Mark occurred.
  • The conflict between internal and external
    balance could have been avoided to a large extent
  • if both monetary and exchange rate policies had
    been under the same authority.
  • But is this politically feasible?.

18
First Steps Towards European Monetary Integration
  • Meeting of Heads of State or Government of the
    EEC at the Hague in December 1969
  • Requests Council of Ministers to draw up a plan
    by stages for creation of an economic and
    monetary union.
  • task proves difficult because of opposing
    economist and monetarist views.
  • economists first a high degree of convergence
    in economic fundamentals and policies
  • monetarists rapid introduction of a monetary
    union followed by economic convergence

19
First Steps Towards European Monetary Integration
  • Creation of Werner Commission in March 1970 to
    address the issue.
  • Werner Report (October 1970)
  • complete liberalisation of capital flows
  • monetary union irrevocable fixing of exchange
    rates
  • community system of national central banks
  • centralised economic policy
  • to be achieved in 3 stages completed by 1980
  • compromise between economist view and
    monetarist view

20
First Steps Towards European Monetary Integration
  • Werner project endorsed by European Council in
    1971 but... was overtaken by events
  • The Marjolin Committee declared the project dead
    in 1975
  • The Snake (in the Tunnel)
  • block floating between March 1973 and Dec. 1978
  • tunnel between April 1972 and March 1973
  • members change frequently and realign frequently
  • snake lasts till 13 March 1979

21
Creation of the European Monetary System (EMS)
  • 13 March 1979 EMS comes into existence
  • Result of initiative taken by Roy Jenkins in Oct.
    1997 and followed up by Helmut Schmidt (German
    Chancellor) and Valéry Giscard dEstaing (French
    President)
  • Based on a European Council Resolution dated 5
    December 1978
  • Main characteristics and operating procedures
    contained in an Agreement Between all the
    Central Banks of the Member States of the EEC.
  • Defined a system of fixed but adjustable exchange
    rates between participating countries.

22
How EMS addressed Bretton-Woods Regime Problems
  • Asymmetry
  • introduction of ECU
  • a basket of currencies of all Member States
  • each currency in the basket assigned a weight
  • the weight could change over time
  • replaced European Unit of Account

23
The ECU A basket of all EC currencies
Belgian franc Belgian (3.301) and Luxembourg
(0.13) franc
24
How EMS addressed Bretton-Woods Regime Problems
  • Asymmetry (contd)
  • introduction of an Exchange Rate Mechanism
  • participation in ERM not obligatory
  • each participating currency assigned a
    (bilateral) central parity with respect to each
    of the other participating currencies (defines a
    parity grid )
  • maximum variation of 2.25 on either side of
    central parity allowed
  • Italy granted exception of 6 on either side.

25
How EMS addressed Bretton-Woods Regime Problems
  • Asymmetry (contd)
  • obligatory and unlimited intervention at the
    margin
  • suppose 1 DEM equalled 20 BEF (central parity)
  • market exchange rate could vary between 19.55
    and 20.45 BEF
  • if market rate reached either bound, both the
    Belgian National Bank and the German Bundesbank
    had to intervene in the market

26
How EMS addressed Bretton-Woods Regime Problems
  • Asymmetry (contd)
  • obligatory and unlimited intervention at the
    margin (contd)
  • if the exchange rate rose to 20.45 (appreciation
    of mark and depreciation of franc)
  • the Bundesbank and the Belgian National Bank
    would have to sell marks and buy francs
  • German Bundesbank at an advantage because it
    could print as many marks as it needed
  • Belgian National Bank at a disadvantage because
    it had a limited stock of marks to sell.
  • Why oblige both to intervene?

27
How EMS addressed Bretton-Woods Regime Problems
  • Asymmetry (contd)
  • obligatory and unlimited intervention at the
    margin (contd)
  • because as a result of the intervention, the
    German money supply increased and the Belgian
    money supply decreased
  • German interest rates fell and Belgian interest
    rates rose, stabilising the exchange rate

28
How ERM addressed Bretton-Woods Regime Problems
  • Realignment
  • At the request of one or several countries
    participating in the ERM, a consultation occurred
    involving the Ministers of Finance and the
    Governors of the Central Banks of all the
    participating countries.
  • These decided whether and to what extent a
    realignment should take place.
  • Consequently, realignments were carried out
    rapidly and with the agreement of the
    participating countries.
  • The consultation often limited the extent of the
    realignment out of fear of loss in
    competitiveness.

29
How ERM addressed Bretton-Woods Regime Problems
  • Speculative Attacks
  • obligatory and unlimited interventions by the two
    Central Banks whose currencies were involved
  • markets would then know that between them the
    Central Banks would not run out a currency
  • this would reduce the probability of a
    speculative attack

30
Functioning of ERM of EMS
  • Four phases in the functioning of the ERM
  • March 1979 to March 1983
  • Participating countries going there own way
    policy-wise. 7 realignments.
  • April 1983 to January 1987
  • Participating countries beginning to recognise
    the constraints on policy imposed by the ERM. 4
    realignments.
  • February 1987 to September 1992
  • The hard EMS. 1 technical realignment
    (Italy).
  • October 1992 to end 1998
  • the period following the breakdown of the EMS
    and preceding monetary union

31
Functioning of ERM of EMS
  • Four phases in the functioning of the ERM

32
Functioning of ERM of EMS
33
Functioning of ERM of EMS
  • Why did the ERM break down in Sep. 1992?
  • Remote causes
  • the system had become too rigid
  • markets convinced no more realignments before
    monetary union (Delors effect)
  • loss of competitiveness of certain countries
  • large capital flows into high interest rate
    countries (Italy, Spain and Portugal)
  • is this compatible with interest rate parity?
  • risk premium.

34
Functioning of ERM of EMS
  • Why did the ERM break down in Sep. 1992?
  • Remote causes (contd)
  • the system had become asymmetric and dependent on
    Germany
  • the Bundesbank set the interest rate for Germany
  • the other ERM countries tied their currencies to
    the German mark
  • the other ERM countries adapted their interest
    rate to Germanys
  • In the ERM, Germany played the role that the USA
    played under Bretton-Woods

35
Functioning of ERM of EMS
  • Why did the ERM break down in Sep. 1992?
  • Proximate causes
  • capital flows (liberalisation of capital flows in
    1990)
  • the Bundesbank hikes up its interest rate after
    re-unification
  • Maastricht Treaty vote in Denmark and in France
  • Solution either floating exchange rates or move
    to monetary union
  • Britain chose floating
  • as did Italy and Spain temporarily
  • fluctuation margins increased to 15 on both
    sides of central parity

36
Functioning of ERM of EMS
  • Impossible or Incompatible Trinity
  • independent monetary policy
  • that is, achieve an internal target
  • fixed exchange rates
  • that is, achieve an external target
  • free movement of capital
  • One of these three goals must be given up.

37
Transition to a Monetary Union
  • The Delors Report
  • The Maastricht Treaty
  • The 3 stages
  • Stage Two preparing for monetary union
  • establishment of the European Monetary Institute
  • countries shall endeavour to avoid excessive
    fiscal deficits
  • the criteria for membership
  • Stage Three monetary union

38
  • Criteria for membership
  • The government deficit may not exceed 3 of Gross
    Domestic Product at market prices.
  • If it does, the Commission must take into
    account
  • whether it has declined substantially
  • and continuously or
  • the excess is temporary in nature. Furthermore,
    it must examine whether the deficit exceeds
    expenditure on investments as well as certain
    other elements

39
  • Criteria for membership (contd)
  • Government debt may not exceed 60 of Gross
    Domestic Product.
  • If it does, the Commission should take into
    account
  • - whether the ratio is diminishing
  • sufficiently and
  • - approaching the reference value at a
  • satisfactory speed.

40
  • Criteria for membership (contd)
  • The inflation rate is sustainable
  • and, over the year preceding examination,
  • does not exceed by more than 1.5
  • that of, at most, the 3 best performing
  • Member States.
  • The consumer price index shall be used

41
  • Criteria for membership (contd)
  • Long term interest rates (on long-term government
    bonds or comparable assets) shall not exceed,
  • over the year preceding examination,
  • by more than 2
  • that of, at most, the 3 best performing Member
    States in terms of inflation rates.

42
Criteria for membership (contd) 5. The Member
State - shall have participated in the ERM
of the EMS and - respected the normal
fluctuation margins without severe tensions
for at least two years before the
examination. It shall not have devalued its
currency against any other Member State's
currency on its own initiative for the same
period.
43
Criteria for membership (contd) Some authors
also add a legal convergence criterion, i.e., the
countries legislation should conform to the
Treaty in matters such as central bank
independence and the ESCB Statute.
44
Transition to Membership
  • Public finances consolidation
  • EMU as deflationary? or stock adjustment?
  • Exchange rate mechanism
  • Real convergence
  • not included in Maastricht Treaty criteria
  • was not a problem for old Member States
  • but may be one for new Member States

45
The Path of the Euro
46
1.2. Recent Macroeconomic Developments in the
Euro Area
47
1.2. Recent Macroeconomic Developments in the
Euro Area
  • Following Relative mild downturn in 2001-2003,
    the euro-area economy experienced a comparatively
    slow recovery
  • In 2006 economic growth is expected to accelerate
    (EC Commission forecast 2.6 increase in GDP
    for 2006) with countries like Finland, Greece,
    Spain, Ireland and Luxembourg growing more than 3
    .

48
1.2. Recent Macroeconomic Developments in the
Euro Area
  • The euro-areas economic recovery is underpinned
    by a strengthening of domestic demand,
    particularly investment
  • Total Investment is expected to grow by 4.2
  • This is due mainly to historically low interest
    rates, improved corporate balance sheets
  • The Outlook for consumption in the Euro Ares in
    2006 is for a modest upturn 1.7 increase

49
1.2. Recent Macroeconomic Developments in the
Euro Area
50
1.2. Recent Macroeconomic Developments in the
Euro Area
  • The euro-areas economic recovery is also being
    helped by the continued strong expansion of world
    output and trade
  • World GDP at 4.6 (strong overall performance in
    China, India, Japan and USA)
  • World trade growth in 2006 is expected to be
    around 8 - with EU exportsto the rest of the
    world growing by 5.5

51
1.2. Recent Macroeconomic Developments in the
Euro Area
52
1.2. Recent Macroeconomic Developments in the
Euro Area
  • The European Commission expects consumer price
    inflation to remain at 2.1 in the euro area in
    2006
  • Core inflation (CPI excluding energy and
    unprocessed food) continued to decline and stood
    at 1.5 in May 2006
  • Oil prices have recently reached record high
    levels of 70 USD per barrel of Brent crude oil.
  • According to Commission estimates price per
    barell in 2006 will average 68.9 USD (27.4
    increase compared to 2005). Effect on Euro area
    CPI should be moderate (see box 1.1)

53
1.2. Recent Macroeconomic Developments in the
Euro Area
54
1.2. Recent Macroeconomic Developments in the
Euro Area
55
1.2. Recent Macroeconomic Developments in the
Euro Area
  • Potential risks to continued investment growth in
    the EU
  • Further increasing oil prices
  • The impact of the budgetary consolidation in
    Germany (increase of VAT from 16 to 19)
    German households may bring forward some
    purchases of durable consumer goods. Hence
    German GDP is expected to fall slightly in 2007

56
1.3. Macroeconomic Policy Settings
57
1.3. Macroeconomic Policy Settings
  • The overall aim of macroeconomic policy in the
    euro area is to keep output close to potential,
    whilst preserving price stability.
  • In the medium term minimization of uncertainty
    of households and businesses about future
    macroeconomic policies stimulating consumption
    and investment decisions
  • The short term responsiveness of policies is
    essential as economic circumstances change
    continuously.

58
1.3. Macroeconomic Policy Settings
  • Monetary conditions Monetary policy has helped
    to spur economic activity and promote confidence
    through historically low nominal and real
    interest rates.
  • Recent increases should help to anchor medium- to
    long-term inflation expectations (see graph 2.2)
  • Interest rates are very low from historical
    perspective the lowest interest rate ever
    attained by the German Bundesbank (BuBa) was 2.5

59
1.3. Macroeconomic Policy Settings
60
1.3. Macroeconomic Policy Settings
  • Inflation rates have stayed close but above the
    ceiling of 2 per cent.
  • Long-term inflationary expectations are below 2
    (see graph 2.4).
  • The euro-areas economic recovery has coincided
    with a remarkable degree of wage moderation (due
    to the behavior of social partners) Low wage
    growth can help to reduce inflationary
    expectations.
  • On the contrary high inflationary expectations
    lead to high inflation and may jeopardize the
    economic recovery.

61
1.3. Macroeconomic Policy Settings
62
1.3. Macroeconomic Policy Settings
  • Fiscal Policy Fiscal policies remain the
    responsibility of individual member states, but
    there are some general requirements set in the EC
    Treaty and in the SGP.
  • Member states can make e positive contribution to
    economic growth by improving the quality if their
    public finance.
  • The euro area is already burdened with too high
    level of debt (see graph 2.8)

63
1.3. Macroeconomic Policy Settings
64
1.3. Macroeconomic Policy Settings
  • Another reason to improve the sustainability of
    public finances is the additional budgetary
    pressure that will stem from the ageing of the
    euro-areas population (see graph 2.9).
  • Change of the old-age dependency ratio
  • Pressure on public finances
  • Conclusions EMUs policy framework has
    contributed to a very favourable macroeconomic
    policy mix.

65
1.3. Macroeconomic Policy Settings
66
1.4. The External Dimensions
67
1.4. The External Dimensions
  • Since its launch in 1999, the euro has become the
    second most important international currency,
    behind the US Dollar.
  • In the first half of 2006, the euro appreciated
    against the US dollar and the Japanese Jen,
    having depreciated in both cases in 2005 (see
    graph 4.1)
  • Interest rate differentials (see graph 4.3) and
    global imbalances (see graph 4.4) will play a
    role in determining whether there will be
    continued appreciation of the euro or a further
    dollar strength.

68
1.4. The External Dimensions
69
1.4. The External Dimensions
70
1.4. The External Dimensions
  • In 2005 US posted the largest current account
    deficit of its history - 6.4 of its GDP
  • Due to persistent differences in saving and
    investment behavior in US.
  • Although the euro area has a roughly balanced
    current account, it would not be immune to
    effects of a disorderly correction in global
    imbalances.

71
1.4. The External Dimensions
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