Chapter 15

Policy Coordination,

Monetary Union, and

Target Zones

INTERNATIONAL MONETARY AND

FINANCIAL ECONOMICS

Third Edition

Joseph P. DanielsDavid D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2

Structural Interdependence

• Structural interdependence is the reason that policymakers might consider the joint determination of economic policies.

• Structural interdependence refers to the interconnectedness of nations’ markets for goods and services, financial markets and payments systems.

3

International Policy Externalities

• Structural interdependences can results in international policy externalities: a benefit or cost for one nation’s economy owing to a policy undertaken in another economy.

• A locomotive effect occurs when an increase in real income in one economy spurs an increase in real income in another.

• A beggar-thy-neighbor effect occurs when a policy action benefits the residents of the home country at the expense of residents in another nation.

4

International Policy Cooperation and Coordination

• There are two ways that nations may work together to achieve their economic objectives.

• International Policy Cooperation is the adoption of institutions and procedures by which policymakers can inform each other of their objectives and share data.

• International Policy Coordination is the joint determination of economic policies within a group of nations, intended to benefit the whole.

5

Aggregate Demand Effects of a Domestic Monetary Expansion

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An Example of a Two-Country Monetary Policy Conflict

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Potential Benefits of International Monetary Policy Coordination

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Potential Benefits of Coordination

1. Take account of and minimize policy externalities

2. Achieve a larger number of policy objectives with available instruments

3. Policymakers may present a “united front” in the face of home political pressures that could push them to adopt harmful policies.

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Potential Drawbacks to Policy Coordination

1. Must sacrifice or forego some domestic interests

2. Must trust that counterparts are willing to make sacrifices

3. Coordinated policies may have negative consequences such as higher inflation (e.g., Bonn Summit of 1978)

10

Hypothetical Welfare Levels for Two Nations

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Discretionary Inflation Bias with Noncoordinated Monetary Policies

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Discretionary Inflation Bias with Coordinated Monetary Policies

13

Monetary Unions

• An extreme type of coordination is for a nation to give up its own currency and adopt a currency common to it and a coalition of other nations.

• That is, form a monetary union.

• For a monetary union to succeed, the coalition must represent an optimal currency area.

14

Optimal Currency Area

• The theory of optimal currency areas is a means of determining the size of a geographic area within which residents’ welfare is greater if their governments fix exchange rates or adopt a common currency.

• An optimal currency area is on in which labor is sufficiently mobile to permit speedy adjustments to payments imbalances and regional unemployment so that exchange rates can be fixed or a common currency adopted.

15

Vehicles Currencies

• A Vehicle Currency is a currency that individuals and businesses most often use to conduct international transactions.

• Since the end of World War II, the U.S. dollar has been the dominant vehicle currency.

• The U.S. dollar is used to denominate over 60 percent of banks’ cross-border positions, nearly one-third of international money market instruments and almost 45 percent of international notes and bonds.

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Exchange Rate Target Zones

• A target zone is a “intermediate” approach to exchange rate management that limits exchange rate volatility while still permitting some variation in countries currency values.

• Specifically, a target zone is a range of permitted exchange rate variation between upper and lower exchange rate bands that a central bank defends by purchasing or selling foreign exchange reserves.

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An Exchange Rate Target Zone

A target zone is a range within which acentral bank permits the exchange rates tovary. If the exchange rate approaches theupper band SU, then the central bank sellsforeign exchange reserves in sufficientquantities to prevent additional depreciationof its nation’s currency. In contrast, if theexchange rate approaches the lower band SL,then the central bank purchases sufficientamounts of foreign exchange reserves tostem any further currency appreciation.Between the upper and lower bands,however, the central bank does not intervenein the foreign exchange market.

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The Behavior of the Exchange Rate within a Target Zone

An oversimplified view of how the exchange rate might vary inside a target zone is that it floats along this dashed line within the target zone, with fixed exchange rate limits at the top and bottom of the zone. In fact, however, speculators in the foreign exchange market alter their demands for the nation’s currency if they anticipate a central bank intervention near either band of the zone. Hence, the equilibrium exchange rate in a target zone actually should lie below the dashed line as the exchange rate approached the upper band of the zone and above the dashed line as the exchange rate approaches the lower band of the zone As a result, the equilibrium exchange rate should lie along a smooth, S-shaped curve.