The European Monetary System, Germany as a Case Study, and the Benefits of Policy Coordination

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From the course by University of California, Irvine

The Power of Macroeconomics: Economic Principles in the Real World

1282 ratings

University of California, Irvine

The Power of Macroeconomics: Economic Principles in the Real World

1282 ratings

In this course, you will learn all of the major principles of macroeconomics normally taught in a quarter or semester course to college undergraduates or MBA students. Perhaps more importantly, you will also learn how to apply these principles to a wide variety of situations in both your personal and professional lives. In this way, the Power of Macroeconomics will help you prosper in an increasingly competitive and globalized environment. This course is also available in Portuguese. To join the fully translated Portuguese version, visit this page: https://www.coursera.org/learn/macroeconomia-pt/

From the lesson

Exchange Rates, The Balance of Payments, and Trade Deficits

The Dollar Standard and Its Collapse 3:37

Today's Hybrid Exchange Rate System, Currency Blocs, and Fixed Pegs3:14

How Chronic Trade Deficits Can Persist, the Multiplier Link and Global Coordination of Fiscal and Monetary Policies 8:12

The European Monetary System, Germany as a Case Study, and the Benefits of Policy Coordination 4:07

Meet the Instructors

Dr. Peter Navarro
Professor
Paul Merage School of Business

[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]

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