The nth currency

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We argued earlier that fixing the exchange rate takes monetary policy out of the hands of the central bank. While this is generally true, it does not apply to all countries in the system. Basically, an exchange rate is simply the price

Rest of the world National economy

Rest of the world National economy

Figure 12.2 The IS-LM and the Mundell-Fleming model complement each other. The Mundell-Fleming model describes the working of the (small) national economy, which is affected by the (rest of the) world income and the (rest of the) world interest rate. The IS-LM model can be used to describe the rest of the world (the world minus our small national economy), and how income and the interest rate in this 'rest of the world' are determined. These then affect the national economy.

Figure 12.2 The IS-LM and the Mundell-Fleming model complement each other. The Mundell-Fleming model describes the working of the (small) national economy, which is affected by the (rest of the) world income and the (rest of the) world interest rate. The IS-LM model can be used to describe the rest of the world (the world minus our small national economy), and how income and the interest rate in this 'rest of the world' are determined. These then affect the national economy.

defends Norwegian kroner/Danish krone rate

Parity:

1.10 NKr/DKr defends Norwegian kroner/Danish krone rate

Parity:

0.88 NKr/SKr

Parity:

1.10 NKr/DKr

Parity:

0.80 DKr/SKr

Denmark:

defends Danish krone/Swedish krona rate

Parity:

0.80 DKr/SKr

Parity:

0.88 NKr/SKr implied by other two parities; does not have to be defended

Sweden nth currency free as a bird

Figure 12.3 A Nordic Monetary System, with Sweden being the anchor. If three countries fix three bilateral exchange rates, one of them may conduct monetary policy as it pleases. If Denmark intervenes to keep the Danish krone/Swedish krona rate at parity, and Norway defends the Norwegian kroner/ Danish krone rate, at the same time they defend the Norwegian kroner/Swedish krona rate. This frees Sweden from the obligation to intervene. In a system with n countries only n - 1 central banks must intervene. The nth country is free.

The Bretton Woods system was a system of fixed exchange rates operational until 1971. It was designed at an international conference held in 1944 in Bretton Woods, New Hampshire. Under the accord one fine ounce of gold was worth US$35. Other countries then defined the values of their own currencies in terms of US dollars.

of one money currency in terms of another. In a way (and we have already looked at this in some detail) this price reflects the relative amounts of the two currencies in circulation. To keep this relative amount at a value that leaves the exchange rate unchanged, you do not need two central banks that cooperate and intervene. If two countries fix the exchange rate, one of the two central banks may move its money supply as it pleases, as long as the other one does exactly what is needed to keep the exchange rate at parity.

As Figure 12.3 illustrates, this also holds if three countries fix bilateral exchange rates. If, in a Nordic Monetary System, Denmark and Sweden were to set the rate of exchange between Danish krone and Swedish krona to 2, it suffices if Denmark intervenes to maintain that rate. If Norway and Denmark fix their kroner/krone rate to 2, then Norway alone can maintain that rate by intervention. But then these two rates implicitly guarantee a Norwegian kroner/Swedish krona rate of 4, without Sweden doing anything. So Sweden controls the nth currency.

The term 'nth currency' derives from the general insight that in a system involving n currencies only n — 1 central banks must intervene. The last one, issuing the nth currency, is free to determine its own course of monetary policy.

Under the Bretton Woods system, operational during the twenty-five years following the Second World War, the role of the nth currency was explicitly assigned to the US dollar. The EMS avoided formally appointing an nth currency. It even required all countries involved to share the burden of intervention. Most experts agree, however, that, in practice, the Deutschmark had adopted the role of the nth currency. So the Bundesbank (Buba) set the pace of monetary policy within the EMS, along with managing the exchange rate with regard to outside currencies like the dollar and the yen. The other n — 1 member countries had the responsibility for keeping exchange rates within the bands around parity values.

The 1992 EMS crisis

12.2

There is an obvious analogy with the relationship between the rest of the world and the individual country studied in Figure 12.2, and with the country with the nth currency in an exchange rate system and the other member countries. In the first case, the rest of the world sets the interest rate with which the individual small open economy must live. In an exchange rate system, such as the EMS or the Bretton Woods system, the nth currency controls monetary policy and generates an interest rate the other member countries have to live with in one way or another. The strains this can put on such a system made the Bretton Woods system collapse in 1971 and pushed the EMS to the brink of failure in 1992. We will use the IS-LM and Mundell-Fleming models to bring out the core issues of the 1992 EMS crisis.

The trigger of the crisis is usually seen as the peculiar mix of fiscal and monetary policy following German unification. A sharp increase in government spending was needed to start rebuilding the public infrastructure and provide financial incentives to attract private investment in the east of the country, and to cushion soaring unemployment. This would shift IS way to the right in an IS-LM diagram for the country with the nth currency. Concerned that this stimulation of aggregate demand may sooner or later trigger price increases, the Bundesbank switched to a restrictive monetary policy, shifting the LM curve to the left. The most striking result from this interplay between fiscal expansion and monetary contraction was a sharp rise in German interest rates, with the money market rate peaking at 9.72% in 1992 (for more details see Case study 12.1).

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