Fear of Floating and the External Effects of Currency Unions

Transcription

1 Fear of Floaing and he Exernal Effecs of Currency Unions Thomas Plümper and Vera E. Troeger Universiy of Essex Deparmen of Governmen Wivenhoe Park Colcheser CO4 3SQ, UK and version: Summary: The inroducion of he Euro has considerably affeced he de faco moneary policy auonomy defined as saisical independence from moneary policy in he key currency areas in counries ouside he European Currency Union. Using a sandard open economy framework we argue ha de faco moneary policy auonomy has significanly declined for counries ha dominanly rade wih he ECU and slighly increased ha dominanly rade wih he Dollar-Zone. The predicions of our model find suppor in he daa. We esimae he influence of he Bundesbank/ECB s and he Fed s moneary policies on various counry groups. The de faco moneary policy auonomy of boh non-euro EU-members and EFTA counries declined wih he inroducion of Euro. This effec was slighly sronger for he EU member counries han for EFTA counries as our heory predics. A he same ime, he de faco moneary policy auonomy of Ausralia and New Zealand vis-à-vis he US Dollar has (moderaely) increased. This finding also suppors our heoreical model. For helpful commens we wish o hank Thomas Cusack, Rob Franzese, Philip Lane, Helmu Lühkepohl, Rick van der Ploeg, Günher Schulze, Rober Walker, Peer Welzel, and Hannes Winner. Ulrike Krämer provided valuable research assisance a very early sages of his projec. Previous versions of his paper were presened a he London School of Economics, he Universiy of Essex, Triniy College Dublin, he European Universiy Insiue Florence, he Ludwig-Maximillians-Universiy of Munich, he Science Cenre Berlin, he Universiy of Freiburg, he Universiy of Augsburg, he Universiy of Hamburg, he Max-Planck-Insiue in Cologne, and he Midwes Poliical Science Associaion annual conference in Chicago, April 004.

2 Fear of Floaing and he Exernal Effecs of Currency Unions 1. Inroducion The inroducion of he Euro exered a srong influence on moneary and fiscal policies in he Eurozone counries. 1 Ye, he influence of he Euro on moneary policies does no sop a he borders of hese welve counries. Indeed, here are good heoreical reasons o believe ha he rise of he Euro has no only alered he rules of he game on inernaional financial markes bu also he decisions of moneary auhoriies around he world. We will argue ha counries ha rade significanly more wih he Eurozone counries han wih he USA now increasingly and more closely align wih he moneary policy of he European Cenral Bank (ECB). A he same ime, counries ha ypically rade more wih he USA han wih Eurozone counries experienced a moderae increase in de faco moneary policy auonomy. We define de faco moneary policy auonomy as independence from moneary policy in he key currency areas. We develop his logic in a parial equilibrium open-economy framework. Our heoreical argumen unfolds in hree major seps: The firs sep is sandard: We adop a classic raional expecaions model, in which moneary policy can be used by he moneary auhoriy o offse he employmen effecs of an unexpeced economic shock. In he second sep, we open he economy and allow exchange-rae flucuaions affecing he domesic inflaion rae. Moneary policy can reduce exchange-rae affecs, bu wih one policy insrumen for wo economic goals sabilizaion of employmen and reducion of he impor of inflaion he moneary auhoriies face a dilemma. This par of our model draws on he fear of floaing lieraure (Calvo and Reinhar 00), which has provided ample evidence for he argumen ha no only pegged counries bu also non-pegged counries lack moneary auonomy because moneary policy is used o sabilize he exchange-rae o a key currency (Shambaugh 004; Calvo and Reinhar 00, Frankel e al. 00). In 1 While all EU counries are members of he European Currency Union, only welve of he 5 EU counries have abandoned heir naional currency and inroduced he Euro. Eurozone counries include Ausria, Belgium, Finland, France, Germany, Greece, Ireland, Ialy, Luxemburg, Neherlands, Porugal, and Spain. In 007, Slowenia became he 13 h counry of he Eurozone. Franzese (00) provides a comprehensive review of he poliical economic lieraure of elecoral and parisan cycles.

3 3 our model he incenive o use sof pegs ha is o sabilize an officially floaing currency resuls from he inflaionary effecs of exchange-rae depreciaions. A reducion of he real ineres rae differenial o key currencies leads o a depreciaion of he domesic currency and in urn o an increase in he prices of impored goods. 3 Since an increase in inflaion lowers governmen suppor, moneary auhoriies especially in small open economies have an incenive o sabilize he exchange-rae (Calvo and Reinhar 00: 391). Accordingly, many counries which are formally floaing, de faco are imporing he moneary policy of he majorcurrency counries. (Frankel e al. 00: 3) In he hird sep, we augmen he fear of floaing lieraure by allowing for more han one key currency. Wih compeing key currencies, he local currency of he counry which reduces is ineres rae depreciaes agains boh currencies. The direcion of currency ouflows deermines he relaive srengh of his depreciaion: he domesic currency depreciaes more relaive o he key currency which aracs a relaively larger inflow of capial. Since he imporance of he US Dollar as major currency has declined relaive o he Euro, he exchange-rae effec for a counry ha seeks o offse a decline in consumpion, employmen and economic growh should now be smaller han before he inroducion of he Euro, while he depreciaion relaive o he Euro should be larger han i was relaive o he Deusche Mark. We hen employ his model o analyze how he emergence of he Euro as a key currency has influenced he de faco moneary policy auonomy of ouside counries. We show ha wheher a counry s moneary policy auonomy increased or declined depends on he relaive value of is impors from he Euro-zone and Dollar-zone. Counries ha primarily impor goods and services from he Dollar-zone, gain in moneary policy auonomy, since he overall inflaionary push of a given change in he real ineres differenial will decline. The opposie is rue for counries ha impor mos goods and services from he Euro-zone. In his case, he inflaionary simulus of a change in he ineres differenial has increased afer he inroducion of he Euro. Counries ha predominanly impor goods and services from he Eurozone should have observed a decline in heir de faco moneary policy auonomy, while counries ha impor mosly from he Dollar-zone should have experienced a small increase in de faco moneary policy auonomy. 3 This holds if corporaions pass-hrough he exchange-rae effec o he consumers. See Shambaugh 005 for convincing evidence ha exchange-rae pass-hrough is common.

4 4 The inroducion of he Euro provides he naural (and currenly, we believe, he only feasible) es case for our heory. 4 We es he predicions of our model in various ways: Firs, we sudy wheher non-emu European counries more closely align heir moneary policy o he Euro ineres rae implemened by he European Cenral Bank. Specifically, we analyze he influence of he ECB s moneary policy on he ineres rae policies of he hree EU members, who did no join he Euro, namely he Unied Kingdom, Sweden, and Denmark. Second, we demonsrae ha he influence of US moneary policy on he ineres policy of hose hree counries has gradually declined since he inroducion of he Euro. Third, we compare he Euro s effec on he moneary policy of hese hree counries o is effec on he moneary policy of EFTA counries (Norway, Swizerland, and Iceland). While he disance of he EFTA counries o he Eurozone s cener of graviy is similar o he EU counries, he EFTA counries impor relaively less from he Euro-zone (and more from he Dollar-zone) and hey are poliically less involved wih he EMU. Fourh, we provide evidence for our model s predicion ha counries which rade far more wih he US han wih he Euro zone (Ausralia and New Zealand) have gradually gained in moneary policy auonomy. And fifh, we show ha Canada a counry ha has used he exchange-rae wih he Dollar as main informaion for deermining he ineres-rae unil does no experience any significan changes in moneary policy auonomy. All hese ess provide evidence in favor of our model. We find ha he Euro decreased moneary policy auonomy in European counries, and arguably more so in he hree non-euro EU counries han in he EFTA counries. A he same ime, he influence of he Fed s prime rae on he ineres rae of hese counries has declined. We also observe a moderae increase in he de faco moneary policy auonomy of Ausralia and New Zealand. These four empirical hus do no rejec our heory. The fifh es-case 6 provides a comparison o a counry for which our model makes no 4 In principle, our heory may be exended o make predicions on changes on counries moneary policy auonomy if one key currency (parly) replaces anoher key currency. The replacemen of he Pound sandard by he Dollar sandard would be he obvious example. While his seems o be rue, he gradual replacemen of one key currency by anoher one akes much longer and is herefore much more difficul esimae han he sepwise increase in he imporance of he Euro relaive o he D-Mark. Moreover, he decline of he Pound and rise of he Dollar were hisorically fosered by he wo World Wars and he Grea Depression, which makes i even more difficul o isolae he effecs our model predics from oher influences on moneary policies. 5 Since hen, he Bank of Canada uses a richer model for seing he ineres rae, bu i has no compleely abandoned he Dollar exchange-rae as reference. 6 This es was suggesed o us by an anonymous referee.

5 5 predicions, because Canada unil a leas November 000 had de faco fixed is exchange-rae o he Dollar and moved in very narrow bands. Therefore, he Bank of Canada had o use is moneary policy o defend he exchange-rae raher han o sabilize inflaion. The Canadian case neverheless adds o he confidence we have ha he resuls we find are no spurious bu indeed sysemaically relaed o he inroducion of he Euro raher han for example globalizaion or financial marke liberalizaion.. Moneary Policy Auonomy in Open Economies Fixed exchange-raes and hus currency unions have crucial advanages. They reduce exchange-rae uncerainy, hereby removing ransacion coss o inernaional rade and fosering economic growh (Rose 000). 7 And since removing exchange-rae pegs is cosly, he pegging counry may borrow moneary policy credibiliy from he key currency s moneary auhoriy (Lohmann 199; Keefer and Sasavage 00). The flipside of pegged exchange raes is he decline in moneary policy auonomy. Since he moneary auhoriy has o defend he peg, i canno use moneary policies for domesic policy goals such as he simulaion of consumpion and invesmen: Under pegged exchange-raes and unresriced capial flows, moneary policies mus rack closely hose prevailing in he counry o which he domesic currency is pegged. (Frankel e al. 00: ). This logic was firs esablished by Rober Mundell and Marcus Fleming in he early 1960s (Mundell 1961, 196, Fleming 196). The rade-off Mundell and Fleming have consiued sill fuels modern poliical economic explanaions of moneary, financial and exchange-rae policies (see iner alia, Bernhard, Broz and Clark 00; Broz and Frieden 001; Rogoff 1985, Giavazzi and Pagano 1988, Canavan and Tommasi 1997). 8 The Mundell-Fleming model is ofen inerpreed dichoomously. Counries eiher peg here currency or hey do no; if hey choose o peg, hey have no moneary policy auonomy while if hey do no choose o peg, hey have full moneary auonomy. Broz and Frieden (001: 3) argue ha pegging ( ) has coss. To gain he benefis 7 Eichengreen and Leblang (003) find no significan and robus relaion beween pegged currencies and economic growh. Bernhard and Leblang (1999) sugges ha counries are more likely o peg heir currencies if hey had a relaively low growh rae before. 8 This model has also informed he heory of opimal currency areas. Accordingly, differen jurisdicions are member of an opimal currency area if rade flows beween hem are relaively imporan (here is much o gain from he removal of rade barriers) and if businesscycles are highly synchronized (here is lile o lose from surrendering moneara policy auonomy). See McKinnon 1961, 196; Bayoumi and Eichengreen 1996, 1997.

6 6 of greaer economic inegraion by fixing he exchange rae, governmens mus sacrifice heir capaciy o run an independen moneary policy. There canno be any doub ha his dichoomous view is a useful simplificaion. However, a imes i exaggeraes he exen o which he choice of an exchange-rae sysem in open economies deermines moneary policy auonomy. Since pegs come wih bandwidhs which can be fairly generous, moneary auhoriies mainain some, albei limied auonomy over moneary policy. Bernhard, Broz and Clark (00: 695) herefore correcly poin ou ha he moneary auhoriy of he pegging counry is, o a large exend, delegaing moneary policy o a foreign cenral bank. (Emphasis added). I is misleading o assume ha a peg compleely removes moneary auonomy. In recen years, an imporan new lieraure 9 has argued ha, in he reverse case, moneary auhoriies claiming ha heir exchange-rae floas ofen follow a sof peg. In his case, moneary auhoriies pursue an implici exchange-rae goal and inervene whenever he exchange-rae deviaes oo much. The main proponens in his lieraure, Guillermo Calvo and Carmen Reinhar, have idenified wo reasons why counries ha say hey allow heir exchange-rae o floa mosly do no. (Calvo and Reinhar 00: 379). The firs is ha exchange-rae flucuaions reduce he abiliy of many counries o borrow on global capial markes. High exchangerae volailiy leads o a risk-premium demand from inernaional invesors. To avoid such risk-premiums, governmens seek o sabilize heir currency s exchange-rae o a key currency or baske of currencies. Secondly and from our perspecive more imporanly, many governmens sabilize heir exchange-rae o key currencies because of wha has been dubbed exchange-rae pass-hrough (Hausmann e al. 001). Exchange-rae pass-hrough has many faces. For insance, in developing counries a depreciaion of he domesic currency may lead o an increase in he value of foreign deb o domesic asses (especially where global capial markes prefer denominaing deb o a key currency). In such cases, he depreciaion of he domesic currency may lead o an increase in he number of illiquid and bankrup firms (especially banks) (Aghion 000). In developed counries he effec of a currency s depreciaion on he price of impored goods seems o maer more. Moneary auhoriies are relucan o 9 Following he ile of an aricle by Calvo and Reinhar (00), his lieraure has been labeled fear of floaing.

7 7 le heir currency depreciae agains he key currencies because hey wan o mainain domesic price sabiliy. Over he pas few years, abundan empirical evidence has been provided in favor of he fear of floaing hypohesis. Hausmann e al. (001: 399) analyze he influence of a change in inernaional prices on domesic prices and find a srong posiive effec. Shambaugh (005) sudies he degree o which he devaluaion of he domesic currency leads o an increase in he prices of impored goods and finds an almos perfec impor price pass-hrough. Boh aricles hus lend suppor o he idea ha impor prices end o be se in he producer s currency. As a consequence, currency depreciaion pushes inflaion upwards. This resul is mirrored by recen research of Campa and Goldberg (005). Disinguishing beween shor-erm and long-erm effecs of exchange rae pass-hrough on impor prices, hey find evidence for boh, wih he shor-erm effecs being slighly smaller han he long-erm effecs. Their resuls also sugges ha exchange-rae pass-hrough is especially high in manufacured goods. The siuaion of moneary auhoriies wih floaing currencies hus sill resembles he Mundell-Fleming rade-off: Cenral banks face a dilemma beween moneary policy auonomy and he desire o avoid impor-driven inflaion. Ye, he severiy of his dilemma does no solely resul from he chosen exchange-rae regime bu also depends on he size of he counry, economic openness, and he exen of exchangerae pass-hrough. Small, open economies impor a relaively larger share of heir domesic consumpion han larger economies. The devaluaion of he domesic currency associaed wih a large exchange-rae pass-hrough leads o a much larger effec on he inflaion rae han a large counry would experience in he same siuaion. Moneary auhoriies in small open economies have severely limied de faco moneary policy auonomy even under a flexible exchange-rae regime. Only large counries issuing key currencies currencies in which inernaional rade is denominaed and capial owners hold heir asses benefi from moneary policy auonomy under flexible exchange-raes. The fear of floaing lieraure provides an exension o he Mundell-Fleming Model raher han a subsiue. The main conribuion of his increasingly imporan and influenial srand of lieraure is he noion ha moneary policy auonomy of many counries is limied even if hey allow heir currencies o floa. The proponens of a fear of floaing approach do no argue ha he de faco moneary policy of floaing currencies is lower han he moneary policy auonomy of pegged currencies. Therefore, poliical economic argumens based on he Mundell-Fleming model are

8 8 ypically sill valid bu hey seem o be oversreched from he perspecive of a fearof-floaing framework. In his aricle we enrich he fear-of-floaing lieraure and combine i wih Alesina a al. s highly influenial work on moneary unions (see Alesina and Barro 001 and 00; Tenreyro and Barro 003) and wih Ronald McKinnon s heory on he advanages of large currency areas (McKinnon 196 and 004). McKinnon argued he role of key currencies in he global economy ceeris paribus depend on he marke size of a key currency area, since economic agens end o favor larger currencies over smaller currencies. Applied o currency unions, his suggess ha everyhing else being equal he use of he union s currency by inernaional financial markes is likely o exceed he use of he union members previous currencies in sum. The case of he Euro provided suppor for McKinnon s heory. The imporance of he Euro on inernaional financial markes goes beyond he role he Deusche Mark, French Franc, Duch Guilder, Spanish Pesea, Ialian Lira and smaller currencies joinly had. In fac, he inroducion of he Euro brough abou compeiion in he choice of he denominaion of bonds, equiies, and oher financial insrumens, which previously had been dominaed by he US Dollar. This has resuled in srucural changes o inernaional financial markes ha have imporan macroeconomic implicaions, as well as implicaions for he moneary policies of counries ouside he union (see BIS 004 and Plümper and Troeger 006). In he nex secion, we will provide a formal model which demonsraes under wha condiions and how he esablishmen of a currency union influences he moneary policy of ouside counries. 3. Exchange-Rae Regimes, De faco Moneary Policy Auonomy and Currency Unions We develop our formal model in hree seps. In he firs sep, we adop a sandard exbook version of a raional expecaions model of moneary policy wih nonparisan cenral banks. Various varians of his model have been suggesed in he lae 1980s (Cukierman and Melzer 1986; Rogoff and Siber 1988; Persson and Tabellini 1990). We follow Persson and Tabellini (000) and Obsfeld and Rogoff (1998) in assuming ha moneary policy is a poliical insrumen, which can be used o offse he unfavorable impac of economic shocks on consumpion. In he second sep, we ransfer he model ino an open economy framework, allowing for capial-flows and exchange-rae effecs. This subsecion incorporaes he common wisdom ha he poenial for capial flows reduces he efficacy of moneary policy.

9 9 We find ha moneary policy becomes a more cosly poliical insrumen if agens can ransfer capial ino oher currencies, as he devaluaion of he domesic currency will lead o higher prices of impored goods and hus o higher inflaion. This effec increases wih he raio beween he consumpion of impored goods o he consumpion of domesic goods. The model is consisen wih he finding ha small open economies are less likely o use moneary policy han large closed economies o offse economic shocks or sheler he domesic economy. The hird sep discusses he influence of a moneary union on he direcion of capial flows and exchange-rae effecs. In brief, he relaive size of he currency affecs he direcion of capial flows, because capial owners have a preference for currencies ha are in high demand. We implicily discuss he logic of exernal effecs of currency unions in a hree-counry model, where one cenral bank uses moneary policy o offse an economic shock (counry 1), while he oher counries remain unaffeced by he shock and mainain sable moneary policies. Accordingly, he capial owners of he firs counry have a choice beween wo safe haven currencies. The direcion of capial flows influences he exchange-rae beween all hree currencies. We will show ha simulaing moneary policy is mos likely if he counry affeced by he shock has relaively moderae impors from he counry issuing he fligh currency. Hence, acive moneary policy becomes less likely if capial flows are re-direced o he prime rading parner as was he case for he European counries ha remained ouside he Euro-zone afer he esablishmen of he European Moneary Union. The Basic Framework: Moneary Policy in a Closed Economy Our model draws on Giavazzi and Pagano s analysis of he ani-inflaionary effecs of pegged currencies (Giavazzi and Pagano 1988; see also Obsfeld and Rogoff 1996: ). The model is based on a cenral bank s loss funcion where boh, subopimal consumpion and inflaion ener quadraically ( ) C C aπ L = +. (1) C denoes opimal consumpion which by definiion canno fall below he acual level of consumpion C. a is a consan weighing he cenral bank s cos of inflaion relaive o ha of subopimal consumpion. 10 Agens raionally expec he inflaion 10 We do no discuss parisan poliics here. Noe however, ha he model is open o allow for a weighing parameer α ha varies beween paries and across counries. By simply assuming

10 e rae π, which is a funcion of he naural rae of unemploymen and he expeced moneary policy 10 ( ) ( r ) 1 E ( r ) e e e π = Ε π θ = Ε θ = π + θ, () where θ represens he naural rae of unemploymen and r e represens he expeced moneary policy (expeced ineres rae) in he absence of an exogenous shock. For simpliciy reasons and wihou loss of generaliy, we sandardize so ha e e π r θ = 0. Following convenions, E denoes he expecaion erm. In a woperiod model inflaion is hus r = (3) π π 1 κ θ where κ > 0 is a consan. In his framework, agens adjus heir behavior aking all available informaion ino consideraion. If cenral banks reac more elasically o changes in he naural rae of unemploymen when facing an upcoming elecion, voers will anicipae he elecoral business cycle. In urn, moneary policy can creae oupu growh and employmen only if he ineres rae cu surprises he economic subjecs. If economic subjecs correcly anicipae moneary policies, moneary auhoriies have an incenive o se moneary policy according o he non-acceleraing inflaionary rae of unemploymen (NAIRU) (Mankiw 001; Ball and Mankiw 003). Thus, he opimal moneary policy sabilizes inflaion a accepable levels while he unemploymen rae approaches is naural rae. This does no mean, however, ha moneary policy auonomy is useless. Cenral banks may sill use i o respond o unexpeced economic shocks. Augmening he cenral bank s loss funcion (equaion 1) by he noion of expeced inflaion and unexpeced shocks we ge e ( ) = π π C + C ε + aπ L (4) ha righ paries have a higher α han lef paries, we can develop his model o explain parisan differences along he lines suggesed by Hibbs (1987). We also do no conrol for parisan effecs in he empirical secion because parisan influences on moneary policies are uncorrelaed wih he various sages of European moneary inegraion we are ineresed in.

11 In equaion 4, unanicipaed inflaion is poliically cosly, since i sharpens random income redisribuions and degrades he allocaion signals in relaive prices. Equaion 4 includes a erm for an idiosyncraic unexpeced economic shock o he domesic economy ( ε ), which provides raional (i.e. non-opporunisic and non-parisan) incenives for moneary policy differences across counries. As in equaion 1, he erm a weighs he poliical cos of inflaion relaive o ha of subopimal consumpion. Lower values of a provide cenral banks wih higher incenives o use moneary policy. Bu even if a is large many cenral banks use moneary policy o (parly) offse economic shocks ( ε ), wih a only deermining he exend o which cenral banks do so hough whaever he cenral bank does, an economic shock will reduce is uiliy. The opimal choice of moneary policy i.e. he firs order condiion for opimal inflaion implies o se 11 L e = ( π π ) C + C ε + aπ = 0 π, (5) which afer some simple ransformaion resuls in e C C + π + ε π = 1+ a. (6) Accordingly, opimal inflaion is higher if agens expec higher inflaion, as well as if he shock is severe, and if acual consumpion is closer o opimal consumpion. Cenral banks can sabilize employmen by responding o unexpeced exogenous shocks of sizeε. When cenral banks do no bring moneary policies in line wih he exogenous shock, consumpion decreases while inflaion remains consan. Ye, his is no necessarily in he cenral bank s ineres. Since boh consumpion and inflaion ener he loss funcion quadraically, he cenral bank is beer off if inflaion increases moderaely and consumpion declines moderaely raher han eiher inflaion increases srongly or consumpion declines in he size of he shock. In oher words: he bes reacion is o parly offse he economic shock. The exac exen o which he cenral bank offses exogenous shocks depends on he weigh a (he lower a, he more cenral bank reac o exogenous shocks). If a = 0, cenral banks compleely eliminae he impac of he shock on consumpion and if a = he moneary

12 1 auhoriy will no reac a all. As equaion 3 reveals he use of moneary policy (hus cuing he ineres rae) in any case increases inflaion: π / r < 0. This seup resembles he workhorse model for moneary policy and i has ofen been used by poliical economiss (Persson and Tabellini 1990, 000, Obsfeld and Rogoff 1996: ). In wha follows, we leave he beaen racks and augmen he model in a way which allows he discussion of moneary policies in open economies ha is, in he nex sep we open he economy by inroducing capial flows and exchange-rae effecs. Moneary Policy in Open Economies The argumen ha cenral banks in small open economies have lower incenives o offse he effec of exogenous shocks is well esablished in poliical economic research. If a cenral bank relaxes moneary discipline while having o deal wih an exogenous shock, i will no only simulae he domesic economy bu also provide an incenive for capial expors (which is mached by an increase in he impored goods and services). Hence, he simulaing effec of cheap money is parly absorbed abroad and his par is larger he smaller he domesic economy is relaive o he res of he world. In oher words, moneary policy is less efficien he smaller and he more open he domesic economy is. We can easily add his insigh o our model. 11 Wihou loss of generaliy, i is mos convenien o model he inflaionary push of lax moneary policy as a consequence of he exchange-rae effec muliplied by economic openness. This view is consisen wih empirical evidence. For insance, David Romer (1993) finds robus suppor for he hypohesis ha more open counries end o have lower inflaion raes. Allowing for exchange-rae effecs of moneary policy draws he aenion back o inflaion, which in open economies depends on domesic moneary policy and on he exchange-rae. Specifically, 1 1 r 1, 1 π = π 1 κ z1, ( X / Y ), (7) θ 11 For simpliciy reasons and wihou lack of generaliy, our model compares closed economies o open economies. In realiy, however, governmens command over so many capial conrols ha capial accoun openness is beer described as discree variable. The effecs ha our model describes will be smaller if a counry parly opens is capial accoun. This implies ha some changes can offse each oher. For example, our model predics ha in he 1990s he Dollar became a less imporan key currency for Ausralia and New Zealand. A he beginning of ha period, however, boh counries liberalized heir capial accoun, which increases he influence of he US Dollar on Ausralia s and New Zealand s Dollar.

13 13 where 1 and denoe wo counries, z 1, is he exchange rae beween he currencies of counry 1 and counry, z1, measures he change in he exchange-rae from period -1 o period. The erm in he brackes denoes expors of counry o counry 1 divided by he GDP of counry 1. 1 π z 1,, 1 1 ( X / Y ) = < 0. (8) Equaion 8 saes ha devaluaions of he domesic currency due o an increase in he money supply or an ineres rae cu leads o inflaionary pressure. We can close our model, because, if we ignore shor-run flucuaions and sochasic rends, he real exchange-rae is a funcion of inflaion and he ineres rae in counries 1 and. Thus, z r π , = λ ( r π 1 ) (9) where λ > 0 is a consan ha reflecs he economic agens risk assessmen of he wo currencies. Equaion 9 saes ha he exchange-rae beween wo counries ceeris paribus follows he real ineres differenial. The real ineres rae does no need o be equal in boh counries, since disequilibrium in he capial accoun can be equalized by disequilibrium in he curren accoun. Hence, he counry wih he lower real ineres rae will be a capial exporer and run a curren accoun defici. Again, his resul is consisen wih he empirical lieraure (Obsfeld and Rogoff 1996: 5-7). Insering equaion 7 ino he cenral bank s loss funcion we ge: L z 1, r 1, 1e = π 1 κ π 1 1 C + C ε θ Y X 1 1 r z1, X + a π 1 κ θ 1 1 Y, 1 (10) Obviously he inflaion rae and hereby he uiliy of moneary policy for he cenral bank no only depend on domesic seings like opimal consumpion bu also on he

14 14 exchange rae effecs of domesic moneary policy. 1 If we now recall from he raional expecaion versions of he Philips curve lieraure ha inflaion raes are basically a funcion of moneary policy and he exogenously given naural rae of unemploymen, hen he smaller he counry is and he more he counry impors from he key currency area, he less likely he cenral bank is o use moneary policy o offse economic shocks. For hese reasons, cenral banks in small counries place a higher value on avoiding exchange-rae effecs and shy away from acive moneary policy. Developing our model in his direcion and aking parial derivaives from he cenral bank s loss funcion (equaion 10) wih respec o exchange rae adjusmens, we observe a decline in uiliy (an increase in losses) if he domesic currency depreciaes: 1, 1 1, 1 L X 1 r z1, X 1e = 1 π 1 κ π 1 1 C + C ε z1, Y θ Y, 1 1, 1 ax 1 r z1, X π 1 1 κ < Y θ Y (11) As equaion 11 suggess, even hough a reducion of he ineres rae increases consumpion, i becomes less desirable in he presence of exchange-rae adjusmens. If he cenral bank cus ineres raes, capial ouflows increase. As a resul, he domesic currency loses value and rising prices of impored goods add o inflaion. 13 Again, our model is consisen wih empirical evidence (see Shambaugh 005). Sysemic Effecs of Currency Unions A his poin, our argumen sars o become slighly more complicaed. To analyze he exernal effecs of currency unions in a comparaive saics approach, we need o considerably increase he number of counries in our model. In fac, we will need one counry o analyze (sill called 1) and hree addiional counries (dubbed, 3 and 4). These four counries are necessary as wo counries have o agree on a currency union (wihou loss of generaliy we assume ha counries 3 and 4 agree on a union), while 1 The final loss funcion where we also inser equaion 9 ino 10 and derive he opimal moneary policy can be found in he appendix. 13 The same holds rue if cenral banks prefer o raise money supply raher han lowering he ineres rae. In his case, agens expec an increase in he inflaion rae, which in urn weakens he domesic currency. The resul is similar o he effec of reducing he ineres rae: domesic consumpion declines and inflaion increases, because impored goods become more expensive. We herefore exclusively focus on ineres-rae cus.

15 15 counry is a compeing key currency area. This seing nicely resembles a siuaion in which counry 1 is he UK, counry he USA, counry 3 Germany and counry 4 France. Consisen wih he empirical evidence, our model assumes ha everyhing else being equal, capial owners end o hold asses in large currencies (Solans 1999; McKinnon 004). This gave he US dollar a convenien posiion as he dominan inernaional currency and assured addiional seignorage income o he Federal Reserve Bank. 14 Wih he inroducion of he Euro, he European currency proliferaed as a second inernaional currency (BIS 004; Chinn and Frankel 005). In early 004, approximaely 40 percen of oal rans-border asses were held in Euro up from a hisorical low of 13 percen in 1984 for he wo dominan Euro-zone currencies, D- Mark and French Franc, ogeher. The Euro has eroded many of he barriers ha segmened he European marke and gave rise o a unified marke comparable in size o he one denominaed in US dollars (Plümper and Troeger 006). 15 The new posiion of he Euro affecs he behavior of capial owners in case of an asymmeric economic shock in a counry no belonging o he Euro-zone. Though he BIS does no repor he geographical composiion of bank s cross-border posiions, he role of reserve currencies on he inernaional asse marke is likely o have a regional bias. While he Dollar is sronger in Lain America and demand for he Yen is higher in Eas Asia, he share of he Euro in cross-border bank posiions in Europe exceeds 50 percen. I hus seems safe o argue ha he Euro has become he main currency for European capial owners soring heir asses in a foreign currency because heir home counry uses moneary policy o offse an economic shock. These changes on global capial markes affec capial flows beween currencies (no necessarily beween counries) and hereby exer an influence on he exchange rae. Since his argumen lies a he hear of our model, le us make he underlying logic clear. Suppose a world of hree currencies (refer o hem as Pound, Dollar, Euro), in which capial owners of one currency (he Pound) search for more aracive asses when ineres raes plunge. In principle, a drop in he ineres raes may imply a shif from he bond marke and from shor-erm asses o he sock exchange. Ye, a cu in one counry s shor erm ineres raes also propels some asses ino shor-erm asses denominaed in oher currencies and especially in key currencies known o be 14 Porer and Judson (1996) esimae ha approximaely percen of he US currency is held abroad graning roughly 0 billion Dollars of seignorage o he US Treasury. 15 This also holds rue for he denominaion of inernaional conracs in raded goods and he denominaion of bonds, where he Euro ousripped he Dollar already in For more deails, see Galai and Tsasaronis 001; BIS 004.

16 16 safe havens. Accordingly, he capial-owners in our example could shif heir asses o eiher of he wo oher currencies or hey could choose any combinaion of he wo currencies. Assume Pound-owners ransferred heir money exclusively ino he Dollar, hus refusing he Euro as safe haven. In his case he Pound would depreciae agains he Dollar and he Euro, bu he Pound depreciaion agains he Dollar would be sronger han agains he Euro. In oher words, he direcion of asse flows afer a reducion in he real ineres rae differenial affecs he relaive srenghs of he exchange-rae effec in a sysem of currencies. This example resembles he sae of global finance before he inroducion of he Euro. The Dollar was he mos aracive safe haven when a counry significanly reduced is domesic ineres rae. In his period, whenever here was an exogenous shock in one counry, is currency depreciaed more owards he Dollar han i depreciaed owards he D-Mark, he French Franc or oher minor reserve currencies. In urn, he Dollar no only appreciaed vis-à-vis he currency of he counry which adjused is ineres rae o lower demand; he US currency o a lesser exen also appreciaed owards all oher currencies. When capial-owners perceive boh alernaives as being equally aracive, hus ransferring abou equally sized pars of heir capial ino he Dollar and he Euro, he depreciaion of he Pound o he Dollar becomes smaller, while he depreciaion of he Pound o he Euro becomes larger. The model developed so far can easily be augmened o allow a concise represenaion of he effecs of currency unions on he moneary policy in hird counries. For his purpose, we have o change he simplifying reamen of he impac of changes in he real ineres differenial on he exchange-rae. Recall from equaion 7 ha inflaion is affeced by he exchange-rae. A depreciaion of he domesic currency implies an increase in he inflaion rae. Now assume ha moneary auhoriies of counry 1 for whaever reasons reduce he ineres rae. 16 The change in counry 1 s moneary policy brings he sysem ino disequilibrium. Since he cenral bank of counry 1 reduces he ineres rae, counry 1 becomes a capial exporer. In line wih he empirical evidence presened in he preceding subsecion, he direcion of capial ouflows from counry 1 is deermined by he relaive counry size and he srengh of he size bias (Mundell 1964). For our 16 For convenience reasons, we assume ha all capial accouns and curren accouns have been balanced and all ineres raes were idenical prior o he shock. The argumen does no depend on his assumpion, bu solely makes he mahemaics more racable.

17 17 argumen, he srengh of he size bias is no imporan. However, our argumen depends on is exisence. To deermine he impac of an asymmeric economic shock on four counries which mainain a flexible exchange-rae regime, we need o model he invesors size bias explicily. A simple mahemaical accoun for exchange-rae flucuaions in he presence of size effecs is z z z ( r π 1 ) 3 3 ( r π 1 ) 4 4 ( r π 1 ) ( N ) 1 1 ( 1+ b ) r π 1 1, = ( 1+ b ) ( 1+ b ) ( 1+ b ) λ Y + Y3 + Y4 ( N ) 1 1 ( 1+ b ) r π 1 3 1, 3 = ( 1+ b ) ( 1+ b ) ( 1+ b ) λ Y + Y3 + Y4 ( N ) 1 1 ( 1+ b ) r π 1 4 1, 4 = ( 1+ b ) ( 1+ b ) ( 1+ b ) λ Y + Y3 + Y4 Y Y Y (1) where z1,i 1 measures he exchange-rae effecs beween he currencies of counry 1 and he oher 3 counries induced by moneary policy changes in counry 1. 0 b accouns for he size bias. If b = 0, invesors use all currencies according o counry size, if b > 0 invesors overweigh larger currencies in heir porfolio. Equaion 14 suggess ha a crisis-ridden counry s exchange-rae wih large reserve currencies devaluaes slighly more han he counry s exchange-rae wih smaller reserve currencies. Again, here is considerable evidence for such a safe haven effec. For insance, he currencies of counries mos heavily affeced by he Asian crisis, Souh Korea, Indonesia, and Thailand (Radele and Sachs 1998; Kaminsky and Reinhar 1999; Hausken and Plümper 00) los approximaely 80 percen of heir pre-crises value agains all major currencies, bu he drop vis-à-vis he dollar was significanly larger. Accordingly, he Dollar appreciaed vis-à-vis all oher major reserve currencies. 17 Therefore, he assumpion ha we make here seems o be valid. We now can reconsider he par of equaion 10 which ses cenral bank losses in relaion o currency depreciaion in Counry 1. Le, 1, 1 1 z1, X z1, X =... + a L Y Y (13) 17 In his respec, he Asian Crisis is no an isolaed case. Japanese economiss have a imes analyzed ineria in he use of he Dollar as means for he sore of wealh. See Ogawa and Sasaki 1998.

18 18 be he parial exchange-rae effec on uiliy. Hence, insering equaions 1 ino 13 and simplifying he equaion gives ( π ) ( ) ( π ) ( ), ( 1+ b ) 3, ( 1 b ) X r 1 ( N ) Y + X r 1 ( N ) Y ( 1+ b) ( 1+ b) Y λ r π 1 Y Y λ r i π 1 Y 1 i i i ( 1 a) = = L = + (14) 4, ( 1+ b ) X ( r π 1 ) ( N ) Y ( 1+ b Y λ ) ( r π 1 ) Y i= i Equaion 14 migh look inconvenien bu i jus describes he sum of all parial effecs. Wih respec o he oal loss in uiliy for he cenral bank in counry 1, boh equaions provide us wih unsurprising resuls: he losses are larger 1) he smaller counry 1 is relaive o he oher counries, ) he more open is economy, 3) he larger he ineres rae cu and 4) he more elasically voers will reac o changes in inflaion (he larger α ). In addiion, equaion 14 has some ineresing properies which we have no ye discussed: if counry 1 s impors from counries -4 are idenical, hen losses are higher he less equal he sizes of counries -4 are. In he same vein, losses are smaller, he less goods and services counry 1 impors from he larges currency. These resuls of he model find suppor in he empirical lieraure. Ariel Bursein e al. argue ha impor prices are highly correlaed wih he exchange-rae of he key currency even if we conrol for consumers demand elasiciy (Bursein e al. 00). Wihou loss of generaliy, we may assume ha counries 3 and 4 form a currency union. Equaion 14 hen simplifies o, ( 1+ b ) 34, ( 1 b ) X ( r 1 π 1) ( N ) Y + X ( r π 1 ) ( N ) Y 34 L = ( 1+ a) +, (15) 1 ( 1+ b) ( 1+ b) ( 1+ b) ( 1+ b) Y λ ( r π 1 ) Y + Y 34 Y λ ( r π 1) Y + Y 34 where 34 denoes he currency union beween counry 3 and counry 4. This finally allows us o obain he ne exernal effec of he esablishmen of a currency union on counry 1 by subracing equaions 14 and 15 from each oher:

19 19 ( π ) ( ) ( π ) ( 1 ) ( π ), , ( + b ) ( 1+ b ) X r 1 ( N ) Y X r 1 ( N ) Y ( 1+ b) ( 1+ b) ( 1+ b) ( 1+ b) Y λ r π 1 Y Y 34 Y λ ( r π 1) Y Y ( ), ( ) ( b ) +, X r N Y 1 ( 1+ b ) X r π 1 ( N ) Y 3 1 L ( ) ( 1 ) 1 4 CU = + α ( 1+ b Y λ r ) π ( 1+ b) Y Y λ i= i ( r π 1 ) Y i= i X ( r π ) ( N ) Y Y ( r π 1 ) Y 4, ( 1+ b ) ( 1+ b λ ) i= i (16) We find ha he ineres rae differenial o counry becomes less imporan for counry 1. This suggess ha he influence of he US cenral bank on moneary policy in non-emu European counries has declined. A he same ime, he join impac of counries 3 and 4 (afer hey had joined a currency union) exceeds he aggregaed impac of he wo counries when hey issued wo separae naional currencies. Accordingly, moneary policy in non-emu European counries follows he European Cenral Bank's moneary policy more closely han i had been he case wih he influence of German moneary policy prior he inroducion of he Euro. However, equaion 16 is no sricly negaive. More precisely, i is negaive for counries which impor more from he currency union ( 34 ) han from counry. However, equaion 16 becomes posiive if counry 1 s impors from counry exceed is impors from he currency union members. In addiion, he smaller counries 3 and 4 had been before he union, he smaller he exernal effecs of currency unions. The more counry 1 impors from counry (counries 3+4), he higher he probabiliy ha he creaion of he currency union increases (decreases) moneary policy auonomy of counry 1. Discussion and Hypoheses A leas a a firs glance, he model developed in his secion seems relaively complicaed. However, hese complicaions added o a simple open economy model are fully jusified as our model allows he derivaion of muliple hypoheses, all of which should be open o rigorous empirical ess. In respec o he de faco moneary policy auonomy of open economies our model makes he following ceeris paribus predicions: Firs, moneary auhoriies in smaller counries are less likely o use moneary policy for domesic poliical purposes (i.e. o simulae he economy or offse economic shocks). Second, de faco moneary policy

20 0 auonomy is smaller he higher he raio of impors o GDP. Third, de faco moneary policy auonomy declines in he raio beween he impors from he key currency area and GDP. And fourh, de faco moneary policy auonomy declines wih he degree of exchange-rae pass-hrough (he exen o which impor prices increase when he domesic currency depreciaes). Clearly, hese hypoheses can be saed in he probabiliy o which governmens choose an exchange-rae peg. Accordingly, governmens are more likely o fix he exchange-rae o a key currency (or a currency baske), when he counry is relaively small and open, when he counry impors a relaively large share from a key currency area and when impor corporaions end o increase prices if he domesic currency depreciaes. Since he above hypoheses have been derived from oher models and since hese hypoheses are consisen wih he empirical evidence, our analyses focus on he novel predicions of our model: Hypohesis 1: The creaion of a moneary union influences moneary policy auonomy of non-members (see eq. 11). Furhermore, he esablishmen of a union s currency influences moneary policy auonomy of non-members he more he larger he gain in imporance of he union s currency on global financial markes relaive o he sum of he union-members' previous currencies. Hypohesis : The influence of oher key currencies on he moneary policy of hird counries gradually declines in he presence of a size bias when a currency union is esablished (see eq ). The dependency of hird paries moneary policy on he moneary policy of he nonunion s key currency (he Dollar) declines, while is dependency on he union s key currency (he Euro) increases. In he aggregae, hird paries may well gain or lose in moneary policy auonomy. They will gain (lose) if hey impor more (less) from he Dollar area han from he Euro area. In oher words, hird paries will lose de faco moneary policy auonomy if he larges share of heir impors comes from he counries ha have joined he moneary union. Hypohesis 3: The esablishmen of a union s currency reduces (increases) moneary policy auonomy of non-members if he non-members impor more (less)

21 from he union s currency area han from oher key currency areas (see eq ) Research Design The heoreical argumen presened in he previous secion implies ha he esablishmen of a currency union has effecs on he moneary policy of counries ouside he union. These exernaliies are more pronounced in counries ha obain a relaively large share of heir impors from he unions currency area. In urn, he impac of oher key currencies on moneary policies in hird paries declines. Variables, Daa Sources and Operaionalizaion As dependen variables we choose he change in he acual insrumen used by mos cenral banks o impose heir policy he shor-erm ineres rae (Obsfeld e al. 004; Frankel e al. 00; and Shambaugh, 004). In paricular, we sudy he deerminans of he discoun rae (he rae a which he cenral banks lend or discoun eligible paper for deposi by banks) and he lending rae (he rae ha usually mees he shor- and medium-erm financing needs of he privae secor). The sample consiss of, we believe, all counries o which our heory usefully applies including Canada which is a borderline case. The sample is small, bu one has o bear in mind ha he counries of he European Moneary Union naurally disqualify for esing our heory. Furhermore, es cases mus saisfy a lis of condiions: Firs, hey mus have implemened a floaing exchange-rae sysem or use wide bandwidhs if hey have pegged heir currency, because pegged counries wih narrow bandwidhs need o use heir moneary policy for sabilizing he exchange-rae o heir anchor currency. If his is no he Euro (he US dollar in he case of Canada) he inroducion of he common European currency should have no effec on de faco moneary policy auonomy. Therefore, we do no expec o find an observable influence of he emergence of he Euro on Canada s moneary policy. Second, counries should no have experienced a period of hyperinflaion beween 1980 and 005 as his would be difficul o deal wih in he esimaion. Third, counries should have had a responsive governmen (democracy) hrough he enire period, since he uiliy funcion we have assumed is oherwise unlikely o be valid. Specifically, moneary auhoriies in auocraic regimes do no necessarily boher abou impored inflaion. And fourh, counries should be relaively open o impors, because

22 counries wih a low raio of impors o GDP do no need o care abou impored inflaion. Finally, we also believe ha Japan disqualifies, since he decade of deflaion in Japan made he counry s moneary policy immune agains impored inflaion for much of he las fifeen years. This leaves us wih four groups of es cases: In he firs group we have he EU members ha have absained from implemening he Euro: he UK, Denmark, and Sweden. Since hese counries receive mos of heir impors from he Eurozone counries, our heory predics he sronges decline in de faco moneary policy auonomy. 18 We use hese counries o es hypoheses 1 and in a firs se of ess. The second group consiss of EFTA counries. Norway, Swizerland, and Iceland impor less han he EU counries from he Eurozone, bu impors from Eurozone counries sill exceed impors for he USA. 19 The hird group includes New Zealand and Ausralia. These wo counries boh have a relaively low rade openness bu impor more goods from he US han from he Eurozone. 0 We should no expec a srong effec of he Euro on moneary policy in hese wo counries bu since we should expec an increase in moneary policy auonomy, New Zealand and Ausralia allow a direc es of hypohesis 3. All foremenioned counries eiher allow heir currencies o floa or have implemened a de faco peg wih broad bandwidhs. The las counry in our sample is differen. Unil November 000, Canada had de faco pegged is Dollar o he US dollar and employed very narrow bandwidhs in which exchange-rae flucuaions are allowed (+/-%). Since hen, he Bank of Canada uses a forecasing model o se is prime ineres rae, which is sill basically in line wih he Fed s moneary policy. 1 For almos he enire period under observaion, he Canadian moneary auhoriies needed o use heir moneary policy o defend he pariy agains he US dollar. For 18 The hree EU counries impor on average over he period under observaion 50 percen of all impors from he Euro-zone and only 8 percen from he US. 19 The hree EFTA counries impor abou 40 percen from he EMU and abou 8 percen from he US. 0 Ausralia and New Zealand impor on average 0 percen from he US and 13 percen from he EMU. 1 The Bank of Canada decides on eigh pre-se daes wheher or no o change heir key ineres rae (he overnigh rae). The Bank follows an inflaion arge (currenly of wo percen) and uses an economic projecion based on a model of he Canadian economy, an analysis of he informaion from moneary and credi aggregaes, ineres rae credi spreads and changes in credi access, and informaion on he ineres rae expecaions of paricipans in financial markes for decision-making. Canada radiionally impors mos of is goods and services from he US (more han 65 percen on average) whereas only a negligible small share is impored from he Euro-zone (abou 6 percen). Therefore, even if Canada would have implemened a more flexible