Introduction to Economics PDF

06/09/2024 Introduction to Economics (course 1) Chapter 1 – why the eu? Why a single currency? Section 0 – Introduction about expectations Several expecta° in economics:  Perfect expecta°: the time is 10:19 & I except that in 1 min the...

06/09/2024 Introduction to Economics (course 1) Chapter 1 – why the eu? Why a single currency? Section 0 – Introduction about expectations Several expecta° in economics:  Perfect expecta°: the time is 10:19 & I except that in 1 min the time will be 10:20. Related w/ natural phenomenon (bend mark).  Adaptive expecta°: using the past & present info, we made expectations abt the future as an average btw past & present. (4 ex, if our parents give us 10 euros in Oct 2022 & 20 euros in Oct 2023, you may adapt your expecta° 4 an amount btw 10 & 20 euros in Oct 2024).  Rational expecta°: Expecta° abt the future are made using not only the past & present info but also changes in the trends. The only thing that we do not anticipate = the unexpected & the surprise.  Self-fulfilling expecta°: the unexpected outcome = realized only bc ppl (behavior). Section 1 – Why the EU? The European construc° = motivated by a political will & also geopolitical perspective in order 2 stop European wars btw FR, GER & UK. Besides, this ID was 2 link both politically & economically western economies bc their interdependence may allow exchanges 2 take place peacefully. The European project = lengthy (6 decades) w/ various phases. Section 2 – Why a single currency? Why it took so long 2 achieve the EU or what countries may win by choosing 2 be part of a common structure? 3 phases: - PHASE A: the monetary integra° = achieved in 2 steps  STEP 1: from monetary autonomy to the imperfect monetary imperfec° The exchange rate It provides the exchange btw 2 currencies (4 ex, 1 euro = 1.11$). In particular we can define CERTAIN (= value of 1 euro into another currency) & UNCERTAIN (= amount of one value of one currency into our currency). The nominal exchange rate The 1 that we see in markets. The real exchange rate Corrected by infla° & even the effective exchange rate. The effective exchange rate Corrected by trade. Trade Linked w/ imports & exports. Imports Referred 2 goods & services bought by 1 country outside its frontiers. Exports Referred 2 goods & services produced by a country inside its frontiers & sold abroad Inflation Related w/ the increase in the consump° price index. REMARK: While infla° focuses on consump° prices, the GDP deflator focuses on both consump° & investment prices.  Inflation Δ > 0 = Pt – Py > 0 (If inflation refers 2 a + varia°, defla° can be symmetrically defined as the opposite of infla°).  ΔP = Pt – Py < 0 (decrease $). In addi°, we may sometimes observe a phenomenon called disinfla° (≠ infla° & defla°). Indeed, it illustrates a case with infla° but w/ descrease in infla° (8%  5%  4%).  Fixed exchange rate: the value of the domestic currency = fixed relative to another currency, usually a powerful & stable one. (EX: euros, dollars, yens)  monetary authority. The Central Bank loses its monetary autonomy because it has to follow the policy of the anchor country. (EX: Bulgaria is linked to the euro).  Flexible exchange rate: the domestic currency = free relative to other currencies such as its value = exclusively determined by the market = by changes in the supply and the demand. 06/09/2024 Intermediate exchange rate: The central bank aims at stabilizing its currency by following an exchange value with tolerance bands. (EX: In Republic Czech, the domestic currency is stable with fluctuations limits namely something between fixed & intermediate exchange rate). Domestic value = stable w/ fluctua° limits namely something btw fixed & intermediate exchange rate. We can define the change in the value of the currency as follows: under fixed exchange rate, devalua° (revalua°) signals the decrease (increase) of the nominal of the domestic currency relative to the anchor currency. A deprecia° (aprecia°) signals a decrease (increase) of the nominal value of the currency following changes in the currency market condi°. EX: devalua° fixed exchange rate & expecta. We assumed a fixed exchange rate regime btw the currency of the countries A/B namely 1A=2B. In addi°, we assume that the CB of country A has exchange reserves of 1.000 B. We consider 2 possible scenarios:  Either the economic performances of country A are worse than those of country B (higher unemployment, lower economic growth, or higher deficits) which causes a devalua° pressure on the domestic currency. However, given the fixed exchange rate, the CB of country A wants to defend its currency. It aims at increasing the value of its currency by buying currency A vs reserves B.  Either, there exists a rumor on the market claiming that the currency A would lose some value which generates a devalua° pressure on it. In either of the 2 scenarios, the CB defends its currency by buying it against reserves. However, if the specula° continues the reserves of the CB may rapidly be lost in which case it’s only choice = to devaluate its currency (an exchange rate crisis). In economics, we divide time: the short term (btw 1 day & 1 year); the medium term (btw 5 days & 5 years) & the long term (more the 5y). Usually, the short term = associated to rigid prices, the medium w/ viscous & the long w/ flexible. SUB SECTION A1 When 2 countries A & B wants to exchange their currencies this raises both microeconomic & macroeconomic problems:  Microeconomic pb: - detaining currency = costly namely the transac° cost related to the exchange of currency. Why choosing only 1 currency? - to minimize the transac° cost relative to the exchange. Which currency choose? Obviously the 1 that has the lowest transac° cost & the most stable at the macroeco level.  Macroeconomic pb: - the exchange rate has many determinants including structural, political, psychological as well as related to eco as such controlling the exchange rate = a complicated task. - Monetary policy has both internal goals (=monetary policy autonomy) & also external goals (=the dvt trade at the global level which increases the interdependence of monetary policy). The 2 macro goals, int & ext, = contradictory which generates an imperfect monetary integra° (more than 40y). Sub Section 2 – From the imperfect monetary integra° to the unique currency ID: How can we built from currency A&B a new single currency C? Raises several pb such as technical one (how to implement it?) + institu° who controls it & political auto vs supranationality. EXAMPLE 1: What should be the fonc° of the unique currency? 1) The measurement value (=numeraire Walras). Money = merchandise in which we announce the value of other merchandise. 06/09/2024 2) Intermediates exchange: tks to $, we can broke the barter into two opera°: buying & selling tks to its generalized purchasing power. 3) Reserve value: the deten° of $ provides purchasing power. EXAMPLE 2: How to organize the emission & control of the unique currency? - Technical issues: how to define the unique currency (as a panel of currency or as a new one)? - The weight of the countries in the currency: should each country have the same weight or define the weight in terms of GPD or their popula°? - How will the currency be defended? Who pays for reserves? - Which system of prices (changing currency implies many changes including of psychological order)? - How to impose the new currency (the existence of agreement btw the countries)?  Institutional pb: The golden rule = 1 currency/1CB, the issues are: who is part of the CB? What representativity? What are its task? How to control it?  Economic pb: - A CB = 1 monetary policy: should it be expansionary or restricted? What abt short-term asymmetries? - What are the goals that the CB follows? Monetary integra° (price stability or infla°) or real integra° (eco growth, unemployment, eco dvt). To summarize, the single currency = a knot of integra° as it took more than 40y to adopt the single currency. In addi°, the unique EU CB = related to the concept of supranationality namely considering the goals of the area before the national/domestic goals. Section B: The real integra° B1- From an isolated economy to the imperfect real integra° In autarky we consume exclusively what we produce (former communist countries before 1990). However, autarky = difficult so countries exchange goods, services… Raises issues of competi° related to national independence further related to national supranationality. However, gov don’t want to lose their auto & perform national policies of control such as cartels btw firms, subsides, preferential taxes… All these explana° may allow understanding why we move from autarky to imperfect real integra° B2- From imperfect real integra° to the economic integra° STAGE 1: the crea° of an area of free trade (AFT) We suppress the border tariffs, quantative restitu° as such AFT limits itself to the interior of the area. Next, we can perform the custom union which is = to AFT + common tariff outside the area & common commercial policies  policies for the ext of the area. STAGE 2: the common market (= the custom union + the free mvt of goods, services, people, capitals…). STAGE 3: The economic union which involves the unifica° of national public policies & harmoniza° of short-term policies. Btw the eco union & the integra° there = 1 step left, since eco policy requires financial ressources namely $. We go back therefore to the PB of supranationality & currency as the knot of integra°. This explains why our Europe stays trashed btw the common market & eco union. Section C- Conclusion There exists 2 types of integra°: real & monetary & the link btw the 2 = the currency. EXAMPLE: Before 1865, in the US, the commercial & financial activity was performed in the federa° of the states. In 1865, the 1st national act bank imposes by law a single currency ($) which further accelerate the real integra°. In sum, the monetary integra° causes the real integra°. In EU, before 1957, the trade performed btw independent countries. 06/09/2024 The Treaty of Rome launches the common market & therefore the promises for the real integra°. Nevertheless, countries have difficulties giving up their monetary auto & they imposed a pace of monetary integra° that = below the 1 required by the market as such in EU, the real integra° did not cause the monetary integra°. This is why it took 40y to perform a true integra°: the 1992 treaty of Maastricht focuses as if it by chance on 2 things: the common currency & on an EU CB that = common & autonomous. REMINDER: the currency = always the knot of integra°: this is why we cannot talk abt EU construc° w/o understanding concepts such as $, exchange rate, monetary policy, devalua°, interest rate… CHAPTER 2- The European construction: a historical approach Section 0- The origin of the EU monetary construction 1848: VH speaks abt the US of EU in ref to the US. In 1516, Erasme discuses a project for a large EU area. Nevertheless, until the 40s, not clear project for the EU project. WW2 = destructive: 64M deaths for more than 60 countries. The large west EU countries want to find a solu°. There are 3 main reason that started the ID of the unifica°:  WW2: the founding countries of Europe were focusing on democracy & the human rights.  The beginning of the Cold war btw the US & the Soviet Union.  The emergence of a European identity as the countries want to build a common eco & diplo vision inside the area & relative to the ext partners. Section 0-2: From the beginning of the Cold War to the Treaty of Rome State of the art All countries = weakened after the war: massive destruc°, human losses, disrupted eco activity. In sum, the eco must reconstructed for scratch. The world is divided in 2 by the USSR & the US want to extend their influence in EU.  1946: the 1st minister of the UK (Churchill) talks abt a sort of US of EU by insisting on the reconcialia° btw FR & GER. From the start, they’re 2 trends: towards a federalist EU & a unified EU.  1947: The Marshall Plan which provides a conditional financial aid from US to EU in the form of comitial aid: a country receives resources if it helps another country.  The 5th of May 1949: the birth of the Council of EU (to be differenciate from the Council of the UE or the European Council). This pillar of the European construc° includes several institutions:  The European conven° of human rights (1950)  The European court of human rights (1959)  The Parliament Assembly The European emblems: the European flag (1955) that includes 12 yellow stars on a blue background, illustrating the perfec° & the plenitude (no link w/ the number of countries which was higher at the time). REMARK: The Council of EU & the European Court human rights = the 1st supranational institu° in EU. Pillar 3: The Treaty of Brussels (1948) gives birth to the Western Union (=defense pillar) in parallel w/ NATO vs the USSR, which signed the Treaty of Warsaw (1955). In sum, the 3 pillars of the EU construc° focus on justice & defense but there is no sign of eco & currency.  The 9th May 1950: the Declara° of Robert Schuman who talks abt sustainable peace & the joint management of the resources of coal & steel (strategic at that time). This declara° = made 5y after WW2 but 1 day later. The main ID = that the eco dependence implies the political dependence.  1951: the crea° of the European community of steel & coal signed in Paris by the founding countries (FR, GER, IT, BENELUX°. ID = to put the strategic resources on the supervision of a high authority presided by Jean Monnet (= one of the founding father). At knowledge, the key of eco = $ but there nothing abt currency.  1952: following the proposi° of FR in 1951, the 6 countries adopt the European Community of Defense w/ the ID of a European army to replace the national soldiers. 06/09/2024  Unexpectedly, the EU Parliament, in 1954, vote vs this project which marks the end of the ECD. This raises the risk of a new European war which is stopped by the 1957 Treaty of Rome. Section 1 – The European construction from 1957 to 1979 Sub-section A – The foundation & the hesitations To understand the EU construc°, we must solve a dilemma which consists of 2 speech: 1. The eco speech: the increasing necessity to preserve the EU construc° vs inter shocks, to adopt an area of monetary stability & to consider the possibility of some sort of integra°. 2. The political speech which does not want to account for all the dimensions of the integra° as it focuses on the national auto & refuses the supranationality. There is a contradic° btw the 2: 1. on the one hand, try to converge their eco (satisfac°) however w/o considering the possibility of the political speech 2. on the other hand, discussing the possibility of a European Union (the eco speech) but always at a future date (the po speech) In sum, the European construc° is characterized by a monetary strategy of small steps until 1998 (= crea° of the European CB) as we’ll see the Treaty of Maastricht (1992) marks a turning pt bc for the 1st time we make references to exact dates. Section A1 – The Treaty  The 25th March: the 6 founders signed the Treaty of Rome which gives birth to the European eco community. The focus = on the coordina° of eco policy, dvt & libera° of trade but nothing on common monetary policy or the monetary unifica°. The content of the EEC:  The crea° of a common market which includes the custom union as well as the free exchange of goods, capitals, services, people… The crea° of common policies such as the Common Agriculture policy (CAP) & the European Community of Atomic Energy The EEC dispose of its own institu°:  The Commission which a supranational authority; together w/ the Executive of the ECSC + EURATOM which gives birth to the European Comission (1957)  The Council of Ministers which reunites members of the governments of each countries  The Parliament, common to the 3 institu° (ECSC + EEC + EURATOM) = located in Strasbourg & would later become the European Parliament  The Court of Justice REMARK: Since 1993, the EU Community replaces the ECC & all these institu° = still active in the EU. Regarding monetary policy:  Art 103-107: the stabiliza° & exchange rate policy = of a “common interest”  Art 109: it contains the procedures to apply for a change of parity & for countries who have difficulties for their inter payment These measurements = unclear as they have untouched gov sovereignty. The 1st measure that = more precise = the crea° in 1964 of the Comity of Governors of the CB of the member states however has only a consultative power. The summary of the EEC:  Btw 58 & 70, trade was x10  The custom union designed for January the 1st 1968 was achieved 18 months in advance (July 1968)  CAP which started in 1962, allowed a moderniza° of the European agriculture especially under the support  Lastly, the ECC allowed an increase financial solidarity btw countries The short-term eco situation and its consequences 06/09/2024 REMINDER: A gold standard = a monetary arrangement such as 2 currencies = fixed relative to gold which marks that 2 currencies themselves = equally fixed such as they are fairly stable towards the other. Following Bretton Woods agreement (1946-1971), the gold standard become an exchange gold standard such as the value of the USD (35$/ounce ≈ 35g). Late 1967, the British pound = devaluated (abt 14%) & there is a strong speculative on the USD which generates a crisis on the gold market in London: the ounce goes from 35 to 42$/ounce. In what follows, the grp of the CB of the ten decides on March 1968 to dissolve the gold pool: non US CB are no longer allowed to exchange their $ in gold bc the USD lost much of its value. This decision signals implicitly the end of the gold standard convertibility index which takes place in 1971. Numerous speculative attacks to decrease the French Mark & to increase the Dutch Mark (thus speculators believed that the FF was overevaluated & the DM underevaluated).  1968: attack the FF which dives  1969: Raymond Barre, vice president of the EEC, publishes the 1st Barre report, suggesting reinforcement coordina° of short-term policy, the adap° a mechanism of monetary coordina° in EU  1969: the FF = devaluated in August & the DM reevaluated in Oct. In FR, both unemployment & infla° increase = stagfla°. In sum, these events showed the necessity of a higher coopera° in monetary policy in EEC, well beyond the monetary decisions of the Treaty of Rome. Section B – The project of the year 69-71 B1 – The decisions  Dec 1969 in Hague: a meeting of presidents & PM. ID = make a plan in several steps w/ the goal of creating a monetary union (no exact date). Also examine the possibility of crea° a European reserve fund (= a 1st attempt for a European CB) w/ the goal of establishing a common monetary policy (not clear date).  On March the 1st of 1970, the Commission made a proposi° for a plan w/ stages that will lead to an eco & monetary union: the 2nd plan Barre. ID = to advance on unifica°, need common monetary policy. It estimates that it is reasonable to consider a period of 8y for the unifica°. -1st stage (70-71): detailed by the Werner plan of Oct 1970 according to we should move to the 2 nd stage in Dec 1973 which consists of 4 steps: 1. Starting June 1971, the fluctua° bands btw the member states = reduced to + or – 0.6% btw the currencies (reminder the CW system = btw + or – 1%  1958: + or – 0.75%). 2. The intervention of the CB = no longer performed in USD but only in EU community currency. 3. The crea° of an EU fund (FECOM) for monetary corpora° which must gradually become an institu° for the management of European reserves with the ID of being part of the CB community system. B2 – The Facts How the decisions were reported into facts? In May 1971, there = a strong specula° on the DM, the European Commission suggests several to cop w/ this attack. The response of the countries = individual as each country implements its own policy. As a result, the DM = floating (no more fixed exchange rate) & Belgium adopt a double exchange rate regime 1 for public institu° (fixed) & 1 for private sector (flexible). In August 1971, the US president Nixon announces the end of the gold standard: the US stops defending the value of the $ relative to gold. European countries criticize this decision as it introduces uncertainty on the exchange market. In Dec 1971, the Washington agreement establish the increase of fluctua° bands to + or – 2.25%. Before these decisions w/ margins of + or – 0.75%. The instantaneous gap = 1.5% & time gap = 3%. W/ the new margins, the gaps go to 4.5% & 9%. However, relative to the EU currencies, the gap btw the USD & each EU currencies = at most 2.25% instantaneously or 4.5% in time. As a result, the USD become the most stable currency. To fight this, EU countries must be able to reduce the margins btw them. Section C – The European monetary snake 06/09/2024 The decisions in Apr 1971, the Basel agreement impose the reduc° of floating or varia° margins of 4.25% btw the European currencies. Result: no more risk on the EU currencies relative to the USD. However, since each EU currency = still linked w/ the USD, this produces the metaphorical img of a snake in a tunnel.  The Bundesbank must intervene to defend its currency & parity both relative to the USD & FF. To avoid a further aprecia° of its currency, the CB of GER must sell its currency & buy both FF & USD.  In the same time, the bank of FR must appreciate its currency: it buys FF & sells DM.  Period t1: the bank of FR must defend its currency relative to both the USD 1 the DM: it buys its own currency (FF) to try to appreciate it & it sells both DM & USD to try to depreciate it.  At the same time, the Bundesbank must defend its currency only relative to FF: the DM sells its own currency buys FF.  Finally, at period t2, there is no immediate danger of the EU currency, FF & DM relative to USD. However, there = a danger btw them: the bank of FR must buy FF to appreciate it & sell DM to depreciate it, w/ opposite opera° for the Bundesbank. C2- Facts In 1973, 3 new countries joined the EEC: UK, IRELAND & DANEMARK. REMARK: the UK refuses the EU construction which is judged to be integrationist. 3 months after the signature, they already request the renegocia° of the condi° of the comminatory budget. 5m after the signature, the British pound = attacked which caused its floating & in the summer 1972, the ounce goes up from 54 to 70$/ounce. In Feb 1973, the USD = devaluated by 10%; the market judged this devalua° to being sufficient so they lunch a new speculative attack. We decide to simply close the market btw the 3rd & 20th of March. 12th, the Council reacts:  The CB must no longer defend their currencies relative to the USD  The max band btw most ECC currencies = + or – 25%.  19th of March: the EEC currencies = linked btw them but they float relative to the $: the snake went out of the tunnel C3 – The reinforcement of the EU monetary snake In 1973, the emergence of the FECOM which is managed by members chosen from CB governors. Its main func°: 1) It ensures the good functioning of the exchange regime btw countries by establishing the concerta° btw the CB 2) It ensures the compensa° btw assets & liabilities btw the CB. It manages the communitary credits which may be of 2 types: short-term credit w/ a maturity of 1m or 3m & medium-term with a maturity of 2 & 5y. Despite these measurement designed to reinforce the snake, the FECOM critized for its insufficient amount of reserves & its limited competences. This criticism = still valid nowdays. C4 – The disappearance of the snake In May 1973, the gold increase abt 100$/ounce. In June, the DM = reevaluated & the bank of FR loses a lot of USD. In Oct 1973, the 1st oil shop: oil producers decided to reduce their weekly produc° by 5% which increase the price of the barrel from 3$ to 18$. In Jan 1974, FR returns in the snake in the in July 1975 & goes out again in March 1976. In Feb 1975, the Council introduces a system of loans inside the Community. In Apr 75, it introduces the EU currency units which is a basket of currencies in the spirit of special drawing rights which = accounted currency measure used but the IMF. However in Jan 76, the Jamaica conference together marks the end of the Bretton Wood. In the following, we can only observe the failure as EU goes towards the end of the snake. Several reports, 8 in less than 5y, consist on the need to improve the coordina° btw eco & po policies. In sum, all this provides the img of the EU construc° at “small steps” from report to report form inten° declara° to shy measures which technical complexities cannot avoid their failure. The “small steps” strategy consists of a resistance to integrate into the USD area, however, w/o providing a true EU monetary integra°. However, in Oct 1977, the president of the EU Commission, R.Jenkins, holds a vibrating speech to support the process of EU integra°. Section 2 – The European monetary system 06/09/2024 Section A – The strategy of the EMS A1 – The decision Following several meetings in 1978 in Copenhagen & Bremen, during which countries insist on the need of stabilizing their currencies, on the 25th of Dec 1978, the EU Council adopt in Brussels a plan w/ several stages which details the functioning of the EMS. However:  The UK conserves the right to enter the system subsequently  We detail only the 1st stage w/o clear content for the next 1  We’re far away from the bold decisions suggested by RJ since the “small steps” strategy = not questioned REMARK: We observe many similarities btw 1970 the snake & 1978 the supersnake: during crisis, countries perceive the need for EU & they adopt a plan w/ several stages, however, only the 1 st stage = detailed. Nevertheless, in 1978, the strategy = more economically technical bc the disequilibria = larger than 70. A2 – The motivation of the EMS The fight vs bad eco condi° as the 9 = searching for a new monetary order: - Exedentary countries hope that the EMS will reduce the apprecia° of their currency since it has – effects on their exports - Defixitary countries hope that the EMS will provide them financial aid to finance their eco dvt  EU motivation: - The EMS should provide decreasing the exchange rate risk which supports monetary stability & the eco dvt in EU.  Inter motiva°: - The crea° of a monetary stability area capable of compensating the weakness of the inter monetary system -The EMS could partially compensate the undesirable consequences of the US monetary policy - The EMS could become a major pillar of the inter monetary system together w/ the USD & JPN YEN Section B: The technical component of the EMS B1: The changes in the way Central banks interfere on the exchange market The mechanism of the snake = revisited as the new system = organized around the ECU = the European currency unit introduced in 1975. The ECU = the account unit of EU & the measurement instrument of the community. The ECU = defined based on a basket of currencies & its value on the 12th of March 1972 at 11:00 = computed as follow: Currency (1): C= x FF (2): amount in ECU (1) x (2): 1 ECU = 2 FF DM 2,3095 0,825 1,912266 FF 1 1,15 1,15 GBP 8,7423 0,0885 0,773895 1 ECU = 5, 79831 FF & 1 euro = 6, 5597 FF For each currency, we can compute the value of the ECU. The procedure consists of multiplying the value of each currency w/ the weight of each currency in ECU. For ex, following this procedure, we obtain 1 ECU = 5, 79831 FF. The weight of each currency in the ECU depends upon 3 criteria: 1. The weight of trade (exports + imports) of country in the total trade in the community 2. The share of the GDP of each country in the total GDP of the EU 3. The share of the contribu° of each country to the FECOM  The rounding on the po margins 06/09/2024 The defini° of the ECU may be modified every 5y if the weight of a country changed by 25%. Within the EMS, each country characterized by a pivot rate. For ex, for FR, 1 ECU = 2, 5798381 FF. Similar to the previous snake, we conserve fluctua° bands of + or – 25% relative to the new pivot rate. However, we introduce a new mechanism  the divergence threshold = 75% of the floating band. When this threshold = reached, countries must correct this disequilibrium by exchange rate market interven° , domestic monetary policy decisions, changes of pivot rate & monetary policy. The EMS mechanism = better relative to snake bc it implies a symmetry of interven°: it is impossible for a currency to reach its upper band w/o another one reaching at the time its lower band. As a result, the 2 currencies for interven° = known which simplifies the adjustment btw them. In addi°, if 1 country experiences difficulties in its pivot rate, this = w/o consequences on the pivot rate of the other countries. To summarize, the ECU = the denominator of all opera°. The Common Numeraire & its senses to determine the contribu° of each country to the FECOM. The value of the ECU = computed everyday & being more elaborated than the snake. It allowed obtaining rather good results in terms of convergence among the EEC. B2 – An increase financial solidarity between countries The 3 financial solidarity forms from the snake = maintained & reinforced more & for longer time. In particular, the adop° of the EM (13th of March 1979) requires the pulling of 20% of the CB reserves as a counter-part of the gold & the USD. The FECOM provides ECU to the CB: = 1st step towards a more common management of exchange reserves. The types of financial instruments:  The very short-term monetary credits: extended to 3m which can be renewed x2  The medium term financial support = significantly increased  For the less dvt countries, we introduced 5y loans to support their dvt In sum, the EMS provides an enhancement of monetary policies btw following the principle snake such as it is sometimes called the supersnake. Section 3 – The performance of the EMS (1979-1998) Section A – The 1979-1983 period: the 1st difficult ste^s A1 - The 1st month Beginning of 1979, FR & GER argue over the compensating amounts in the agriculture sector related to the varia° of the currencies as such the EMS = delete from Jan to March 1979. The GB signs the EMS but is not concerned by the exchange rate mechanism (+ or – 25% margins) while its currency remains in the eco & it has access to the credits of the EMS. Other countries like IT or IRE require particular condi° such as 5y credit to finance their infrastructure programs. The EMS seem fragile but its functioning = fairly convenient. 23th Sept 1979: the Council of Ministry adjust the pivot rate: the DM = reevaluated by 2% & the Danish Crown = devaluated by 3%. The Ministries of Finance congratulated each other for this coopera° but only 2m after, the DC devaluated by 3%. This chain of devalua° may trigger a risk of credibility loses for financial market. As such as the EMS functioning = more precarious than the politics want to recognize but not surprising that in Feb 1980, we postponed the 2nd stage of the EMS designed to start in March 1981. This recalls the “small steps” strategy. In 1981, the ECU loses value relative to the $ & yen. Analysts criticized for being composed of several currencies (too many) & lacking a robust policy relative to the USD. A2 - The research of autonomy by the French monetary policy & its negative consequences In 1981, the FF = devaluated by 3%, however, this devalua° = judged to be insufficient by the market bc of high interest rate & difficult eco situa°. On 28th of May 1982, the French president takes a flight w/ journalists & the next day, CB loses 300M $ & over 30B FF for the next week. Given the amount of loses, the only solu° left = to devaluate again the FF (occurs on the 13th of June 1982  5.75%). REMINDER: The 0 reset technique In June 82, following 3 devalua°, the FF = devaluated by almost 6%; however, fails to convince the market: the adjustment must be performed relative to the expected infla° differential rather than current differential. In March 83, the bank of FR loses 500M$ (3rd) followed by 500M$ more on the 7th of March in 1h. So, it decides 2 no longer defend its parity. The 17th of March, the FF = devaluated by 5.5% showing the will of the CB to really fight infla° (the beginning of the competitive disinfla° period btw 83 & 92). 06/09/2024 The cumulated of devalua° on the commercial balance (difference btw exports & imports). “J” curve. Section B – The beginning of the P/DM area & its consequences B1 – The multiple adjustments During these years, currencies = anchored to the DM & the EMS works asymmetrically: capitals go towards the higher interest rates (in GER). In sum, there is little monetary policy coordina° & the EMS works as a deflationary device (high interest rates to reduce infla°). B2 – Some technical changes on the EMS In 84, we increase the weight of GER in the ECU. In 85, we allow CB to interfere directly in ECU. In 87, the Mybord agreement in DAN try to increase the flexibility of the EMS.  Weak currency countries may ask support from strong currency countries even below the divergence threshold (75% of 2.25%)  CBs can additionally interfere on the interest rates to control the exchange rate  We increase the number of arrivals used to survey the exchange rate & lastly countries can ask for financing/assistance from the FECOM even below the 74% threshold B3 – The financial European space & the incompatibility triangles On February 86, the signature of the European Unit Act, which = 1 st important modifica° of the 1967 Treaty of Rome. The ID = to restart the process of European construc° to achieve the interior market (common) & to define the Foreign & Security common policy. Institutional changes:  Crea° of the European Council from which formalizes the meetings of the president & the PMs  Reinforcement of the power of the EU Parliament  Crea° of the 1st instance court Political changes:  The goal of the Act = to establish progressively the common market (the free mvt of goods, services & capitals) by dec 1992  It discusses social policies to enhance the health & security of the workers & to dvt social dialogue in EU  Several comminatory policies to reduce dvt gaps in EU (ex: the E U fond of regional dvt)  The Act equally refers to R&D, environmental protec° or common Foreign policy All these decisions generate various types of PBs:  In terms of sovereignty (ex: a FR product that = sold in GER)  Competi° (a product w/o equivalent in another country)  Security (the leveling/harmoniza° of regulatory decisions (the same protec° for savors)  PB of propriety (how 2 deal w/ the propriety rights for an apartment in Spain)  Structural PB (banks & firms must obey 2 the same rules across EU) Monetary policy:  The Act suggests a 2-stage policy composed of the free mvt of long-term capitals (Nov 86) followed by the free mvt of the short-term capitals in June 88. However, these decisions = not supported by common external protec°  Starting from national monetary policies, the ID = 2 create a European national space that will allow for a larger financial diversifica° at microeco level & a better allloca° of financial resources at the macroeco level. The Mundel incompatibility triangle Section C – From the $ Treaty to the Treaty of Maastricht (89-92) Cf. sheme C1 – The $ Treaty = another plan w/ stages signed in Apr 89 Stage 1: 06/09/2024  The reinforcement of the coordina° of eco & monetary policies  Medium-term common policies  No precise date 4 the 2nd stage Stage 2:  The intro of rules (w/o constraints) for the fiscal deficit & its financing  The crea° of the EU system of the CBs  A common monetary policy Stage 3:  The accomplishment of the monetary union by fixing the parties among currencies  The ESCB would become the EU CB w/ the goal of managing the common monetary policy & the exchange reserves REMARK: the lack of clear dates starting the 2nd stage recalls the previous reports & the small steps strategy C2 – the German reunification & its consequences Following the fall of the Berlin wall (Nov 1989), the 2 GER (East & West) decide to unify. To support this process, a massive public spending plan = decided for East GER. Fearing infla°, the Bundest bank decides to strongly increase their interest rate. The other EU countries decide to follow this policy of high interest rate. However, since they were on the low phase of the business cycle, this decision generated a major crisis in 92/93 in the entire EU. REMARK: Relative to the 92 crisis, EU countries make a political decision since they fear that GER would become the leader of a EU focused on the Central & Eastern EU countries, since the Treaty of Maastricht. C3 – The Treaty of Maastricht It = signed in Feb 92 as a treaty for an eco & monetary union that must lead at the monetary integra° btw the 1 st of Jan 97 & the 1st of Janv 99. REMARK: Despite being a plan composed of stages like the previous plans, it supposes an irreversible process towards a supranational monetary union. The crea° of the EU = based on 3 pillars namely internal affairs & justice (art K9), Foreign & Security policy (art J11) & the EU community which becomes the European Monetary Union w/ emphases on monetary issues. Cf. scheme Stage 1 (btw janv 90 & Dec 93) = prepara° phase characterized by:  An increase of eco polices  Increase coordina° of national monetary policies (the EMS remains active)  A higher stability of prices & policies for healthy public finance  Multilateral survivance of the main macroeco aggregates Stage 2 (janv 94  janv 97/99):  Countries must respect “convergence criteria” (evaluated in the final stage)  From a monetary standpoint, the EMS remains active & national CBs must became really independent  The crea° of the EU monetary institute which = a predecessor of the future EU CB since it enforces the coopera° btw EU CBs, enforces monetary policy coordina° to insure price stability, supervises the functioning of the EMS & takes over the tasks of the FECOM which = dissolute.  Besides EMI manages the utilisa° of the ECU & prepares the 3rd stage by elaborating the monetary policy instrument  The composition of the ECU = from starting the 1st Janv 94 in prepara° for the future EU monetary union Stage 3: The last stage (Janv 97/99) following the evalua° of 96 the degree of accomplishment by the Member states of the criteria for EMU particularly regarding the high & sustainable convergence.  It contains 5 strict criteria (art 109J) defined in a protocol on the convergence criteria 06/09/2024 The 5 criteria:  2 fiscal criteria namely a deficit below 3% of GDP & a debt below 60% of GDP 3 monetary criteria: 1) An infla° rate no higher than 1.5% each pts above the average of the 3 countries w/ the lowest infla° rate 2) The 2.25% margins around the pivot rate must be respected at least 2y w/o devalua° 3) The long-term interest rate must not be higher than 2% each pts above the average of the interest rate of the 3 countries w/ the lowest/best inlfa° rate In the following, the Council of Europe decides in June, 1996 when the 3rd stage started (97-99), the countries that respect the convergence criteria do not have the right to refuse the monetary integra°. The EMI becomes the EU CB. The EU CB together the national CBs form the European system of the CB whose sole goal is priostability (art 105) & who = independent. The exchange rates of domestic currencies = fixed relative to the ECU, in some future, the EU must become a full currency & no longer a basket of currencies. THE OBJECTIVE OF THE UNIQUE CURRENCY 1) Europe would display its unity 2) In the context of the globalization of trade, the Euro zone would become a new economic power together w/ USA & JPN 3) An increase competitiveness in a new free trade area thanks to scale economies that may generate increasing returns 4) Money = “an eco weapon” namely an increasing share of the world trade will go through the Europe. To conserve the euro as a major trade currency, it has to be stable. This = the reason why the Treaty of Maastricht focuses on the control of infla° Section D – From the economic imbalances to the introduction of the euro (92-93) The 92 economic crisis This crisis was generated by various factors:  Economic factors 1/ In July 92, the Bundest Bank decides to increase its interest rate while the market was expecting their decrease or at worst their maintain. This restricted monetary policy takes place under a low phase business cycle & in a context where other currencies were already under pressure. 2/ In Sept 92, Finland was a candidate country & allows its currency the Markkaa to float. Since this currency was recently attached to the ECU, this decision generates contagion effect both in Scandinavian countries (the CB of Sweden increased its main interest rate to 75% its all-time record in 300y of existence) & also across EMS countries (the CB of IT increased its IR from 18 to 20.8%).  Political factors 1/ The Danish no: despite a strong political campaign for the yes, on June the 2nd 92, the Danish ppl voted no, regarding their integra° in the Eurozone. The next day, the French president announces that the Treaty of Maastricht will be summited to a referendum in FR. The ID = to show a strong popular desire in FR for the EU construc°. 2/ The French referendum: in June 92, the yes = around 65% of polls but in August, the no = at 52% of the polls. During this uncertainty context, a small yes comes out finally (51.01%) on Sept 28th 92.  Technical factors 1/ The incompatibility triangle of Mundel showing that monetary autonomy = inconsistent w/ a single currency in a context of free capital mvt. 2/ High interest rates leading to many currencies being overvalued. 3/ A policy mixed PB generated by monetary policies that focus on the domestic factors & fiscal policies that do not comply w/ the fiscal rules 06/09/2024 THE DVT OF THE CRISIS On Sept the 8th, the Finnish currency exits the ECU. Specula° moves to the Italian lira devaluated by 7% on Sept 30th & then to the next weakest currency namely the British pound. On the 25th of Sept, the Bank of England intervenes to defend its currency which however exit the EMS on the 16th of Sept. On the 17th, the IT lira exit the ECU, the Spanish peseta = devaluated by 5% & the Bank of Sweden increased its interest rate to 500% w/ the hope of recovering the control of the Swedish crown. On Sept the 15th, specula° continue on the IT lira & the Swedish Crown & new attacks concern on the FF. On the 22nd & 24th of Sept, the bank of FR increases its interest rate to 11 & then 20%. Despite some better times, in Nov, the CB of Sweden allows its currency to float relative to the ECU. 4 days later, 23 rd of Nov, there = a general specula° on all the currencies w/ BCs heavily increasing their IR to try to recover the control of their currencies. The moral of this crisis = that eco convergence btw countries cannot be achieve by law or by a treaty. Instead, it = the result of eco measures & especially of a political will which comes w/ a cost (the loss of monetary policy autonomy). The 93 crisis In a context of law business cycle, the IR in GER remain very high (around 7%) which generates several consequences:  In Feb 93, the Irish pound = devaluated by 10%  In May 93, the Spanish peseta & the Portuguese escudo by 8 & 6.5% respectively  In June 93, there = a strong specula° on the FF, the Belgium Frank & the Danish Crown  All this ends on the 1st of August 93 w/ the explosion EMS: the fluctua° bands = increasing + or – 2.25% to + or – 15% which = a way to recognize the existence of a multispeed Europe composed of countries w/ both strong & weak currencies D2 – The independence of the CB & the policy mix PB The ID: the independence of the ECB = necessary to convince the Germans of the importance of the fight vs infla°. To achieve the independence of the ECB, 1 must implant the principles of time consistency: the CB must display shorter & medium monetary goals & must respect them in order to improve the transparency of its ac°, generating more credibility & efficiency. Explana°: the independence of the ECB means that = only focus on infla° w/o any formal focus on other goals such as eco activity. Increasing IR = attract foreign capitals. This structure has several consequences:  We except a decrease of the IR for eco activity reasons but in light of its price stability goal, but the CB does not take such measures  The loss of one of the component of the policy: monetary policy focuses on infla° alone w/o any interest for employment or eco activity.  In the 1st year, the govs try to compensate the loss of monetary policy autonomy through large expansion fiscal policy generating an explosion of fiscal deficit & debt Cf. scheme REMINDER: the ECB has only 1 goal namely infla°, it = independent (technocratic) & supranational above the na°. As a result, the fiscal policy = left to the national gov which however must respect the fiscal rules imposed by the treaty of Maastricht. The “big jump”: the adop° of the euro (98-02) The timing STAGE 1: In Janv 98, we fixed the parity btw the currencies, create the ECB & nominate the countries which = apt to integrate the Eurozone (who respect the criteria). Despite some fiscal pbs, BEL & IT = however allowed to 06/09/2024 enter the Eurozone on political considera°. We introduce the EMS bis which links the euro to the domestic currencies (for ex, 1euro = 6.55957 FF). STAGE 2: On Janv 1st 98, the ECB becomes operational & the euro becomes a full currency no longer a basket. The exchange rate = fixed forever. STAGE 3: starting the 1st of Jan 2002, the effective introduc° of the euro which takes a physical form. The advantages of the single currency gains:  Reduc° of transanc° cosr btw currencies  Reduc° of uncertainty linked to the exchange of currency (elimina° in the Eurozone) & reduc° outside the Eurozone  Price stabiliza°: low & stable ever since  A rebalancing of monetary powers btw the European countries (we reduce the role of GER & DM in Europe)