“Perhaps they will be lucky. It may be that events, as they turn out in the next 10 or 20 years, will be common to all the countries; there will be no shocks, no economic developments that affect the different parts of the Euro area asymmetrically. In that case, they’ll get along fine. On the other hand, the more likely possibility is that there will be asymmetric shocks hitting the different countries. That will mean that the only adjustment mechanism they have to meet that with is fiscal and unemployment: pressure on wages, pressure on prices.” (Milton Friedman, 1998). Explain this statement and discuss it in the light of developments in the Eurozone since 2009.
Milton Friendman talks about the concerns of the EMU – a monetary union with one currency, the Euro, managed by a sole central bank, launching within the euro area in 1992 resulting in a fixed exchange rate between the members. The statement stresses that by adopting a single currency; the differences in the member countries will result in asymmetric shocks and further problems. This is associated with the theory of optimum currency areas which implies that countries wishing to join the fixed exchange rate area successfully is linked to high economic integration. This statement questions the extent of Eurozone being an OCA. There are many reasons for adopting a common currency - having a fixed exchange rate means that a joining country gives up its ability to use a floating exchange rate and control of monetary policy (therefore unable to control interest rates) for the purpose of stabilising output and employment.
To explain further, I will first talk about the exchange rate framework. A countries exchange rate can be fixed or floating. The open market equilibrium condition is: y t = a t + δ ( s t + p t*- p t ) + g t The FEM is in equilibrium when the interest parity condition holds (when expected rates of return on domestic and foreign currency deposits are equal): i t = i t* + E t s t + 1 - s t + ρ t The domestic MM is in equilibrium money supply equal to money demand: mt-pt = φyt -ηit +εt
Combining these two equilibrium conditions creates the AA schedule which shows the XR and output that are consistent with equilibrium in the MM and FEM. The DD schedule shows all combinations of output and exchange rate for which aggregate demand is equal to aggregate output. This is represented on an AA-DD diagram. The framework for a credible fixed exchange rate requires: Etst+1 = Etst+2 =…st = ś, as interests are fixed to the euro then FEM market equilibrium requires: it = i* (if it*=i* and ρ = ρ *) The CB needs to intervene for ś and it does this by automatically adjusting the domestic money supply mt* by buying/selling domestic currency at price ś so that the interest is equal to the foreign interest rate i* for the exchange rate to stay constant.
Figure 1 – Fixed XR - Insulates Money Demand shock
An Advantage of fixed XR is that it insulates the economy from money demand shocks, whereas under flexible XR, a positive shock would increase Md by putting upward pressure on interest rates and downward pressure on the XR.
The main disadvantage of having a fixed XR is being prone to speculative attacks and currency crisis. (1992 speculative attacks on the EMS)
Figure 2 - Floating XR (impact on Yt of a negative at-shock)
Figure 3 - Fixed XR (impact on Yt of a negative at-shock)
From above, under a flexible XR output does not fall by as much as under fixed XR because of the improvement in CA; when interest rate falls, outflow of domestic assets are lower than foreign assets and for parity condition to hold, people sell domestic currency and therefore the currency depreciates. This is good for the economy because as currency falls, the output will drop by less than under a fixed regime. i.e – DD shift by the same amount but AA does not shift under flexible. The depreciation effectively absorbs demand and this has been a...
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