[MUSIC] In the late 1970s, in the aftermath of the demise of Brenton Woods and the dollar standard, the nations of Europe established a fixed rate system pegged to the German mark. These nations did so in the hopes of avoiding a repeat of the competitive devaluations and economic disruptions that had plagued Europe in the 1930s after the collapse of the gold standard. In fact, this European Monetary System worked reasonably well for over a decade. However, in 1990, the reunification of Germany resulted in large budget deficits as West Germany subsidized East German industry. To cope with the resultant inflationary pressures, the Bundesbank, the German equivalent of the Federal Reserve, significantly raised interest rates. Here, German monetary policy was clearly uncoordinated with that of its neighbors. That is, it was being used for domestic macroeconomic management without regard to its impact on Germany's trading partners. The results, however, were severe. Faced with rising German interest rates, other European countries in the European monetary system, had to raise their interest rates to prevent their currencies from depreciating against the German mark and moving outside the prescribed range of parities. These interest rate increases along with the worldwide recession pushed Europe, outside of Germany, into an ever deepening recession. Eventually, the European monetary system was brought down by speculators who believed that the beleaguered countries would not continue to tolerate unrealistic exchange rates and high interest rates. One by one, currencies came under attack-the Finnish mark, the Swedish crown, the Italian lira, the British pound, the Spanish peseta-and the system collapsed. Macroeconomic lesson of this crisis is that a country cannot simultaneously have fixed exchange rates, open capital markets, and an independent monetary policy. In the wake of this crisis, the major European countries resolved this dilemma by moving to a common currency, the Euro. Was a step that strongly reinforces the importance of coordinating global macro policies. Let's conclude this lesson by illustrating the potential benefits of global coordination with the income possibility curve in this figure. Say that both Europe and America find themselves stuck at point u with high unemployment and low incomes and that the problem is due to high interest rates, stubborn government deficits and strong protectioners lobbies for domestic industries. America considers taking a non-cooperative policy, perhaps introducing trade barriers and raising interest rates to keep inflation down. And this moves America to it's non-cooperative optimum at point NA. Now Europe, likewise considers the same kind of non-cooperative policy, restricting trade, depreciating its currency, or increasing purchases from within its boarders, in effect, moving to its non-cooperative point at NE. And pursuing these non-cooperative policies along the red colored NA NE line, nations would not only beggar their neighbors But beggar themselves as well. The alternative would be to find a cooperative approach that had positive rather than negative spillovers. This might involve lowering trade barriers, having a joint policy of monetary expansion, and tightening fiscal policies to increase savings and investment. If successfully designed and implemented, such a policy might move both America and Europe out to point C on the income possibility curve. [MUSIC]
