Unit 7 Macroeconomic policy in the global economy

7.4 The ultimate Fix economy: A country within a common currency area

As of early 2024, roughly 12% of the world’s population live in countries that do not have their own currency. In addition to the 20 eurozone countries that share a common currency, the euro, some countries adopt another country’s currency—such as the US dollar.

base money, monetary base, high-powered money

Base money (also called the monetary base and sometimes high-powered money) consists of the cash held by households, firms, and banks, together with the balances held by commercial banks in their reserve accounts at the central bank.

A country within a common currency area does not have its own monetary policy. Base money (reserves and currency) is issued by the shared central bank, which controls the policy interest rate. So in the case of the eurozone, the European Central Bank issues euros and sets the policy rate for the 20 member countries, which all use the euro.

What about the exchange rate?

The exchange rate for any given member country against countries outside the currency union is the same, and it is determined by the exchange rate of the common currency against other global currencies. Therefore, the nominal exchange rate of the euro fluctuates on a day-to-day basis relative to the dollar, the yen, the Chinese yuan, and many other currencies. For this reason, the IMF classifies the euro as a fully flexible currency, like the Japanese yen, the British pound, and the US dollar, for example.

But what about exchange rates between member countries?

Before the eurozone was created, member countries all had their own currencies. But now that member countries all use the euro, you may think that the concept of a nominal exchange rate between eurozone members is simply not relevant. From an economist’s perspective, however, there is still an exchange rate, but for all member countries, \(e = 1\), and this exchange rate simply cannot change.

So, for example, Spanish euro coins have a different design from German euro coins but Spanish euros and German euros can be used interchangeably. Since they can be exchanged one-for-one, the nominal exchange rate between Spain and Germany (and all other countries within the eurozone) is fixed at \(e = 1\).

Hence, the economy of a country that belongs to a common currency area is ultimately a Fix economy, with a fixed exchange rate, and interest rates entirely dependent on monetary policy set elsewhere (in the eurozone by the ECB).

An example: Spanish and German currencies before and after the euro

unit of account

A standard unit that is used to measure and compare the market value of different goods and services. One of the functions of money in the economy is to act as a unit of account.

Before they joined the eurozone, both Spain and Germany had their own currencies. In Spain, as discussed in Section 7.3, for example, all prices were measured in terms of the Spanish currency, the peseta. During this period, the peseta was therefore the unit of account in Spain, while the Deutsche Mark (DM) was the unit of account in Germany. Figure 7.10 shows that the nominal exchange rate between the peseta and the DM fluctuated significantly, and that for a number of years the peseta depreciated rapidly against the DM.

With the introduction of the euro in 1999, both currencies were converted into the new currency, the euro, at pre-agreed rates. For Spain, the peseta was converted at the rate Pts 166.4 = €1. For Germany, the DM was converted at the rate DM 1.96 = €1. Specifying Spain as the home country, we could therefore think of the nominal exchange rate, \(e\), between the peseta and the DM as being effectively fixed indefinitely from that point onwards at 166.4/1.96 = Pts 85 per DM.

These conversion rates actually continued for many years after the eurozone was created. Until 2021, if you found an envelope full of peseta banknotes in a drawer somewhere, you could take them into an office of the Bank of Spain, and convert them into euros at the same fixed rate. The Bundesbank went further: even today (as of 2024) if you happen to find an envelope of DM notes, you can still convert these into euros. So up until 2021, at least, this fixed peseta/DM exchange rate did effectively survive in this limited form. An envelope containing 1,000 DM had the same value as an envelope containing 85,000 pesetas. Aside from rounding errors, you would have got the same number of euros when exchanging the contents of each envelope.

But since in 1999 both countries adopted a new currency, the euro, they simultaneously both changed their unit of account to be the euro. From that point onwards, since both countries measured prices in euros, we can also view the nominal exchange rate between their notional currencies as being fixed at \(e = 1\), and this is the approach we take in what follows.

Real exchange rates within a common currency area

Being a member of the eurozone fixes nominal exchange rates permanently against other members of the eurozone. But for effects on the real economy in their country (output, employment, and so on), we need to think about the real exchange rate. The formula for the real exchange rate shows that fixing the nominal exchange rate does not fix the real exchange rate.

In what follows, we again take a Spanish perspective—Spain is the ‘home’ country, and Germany is ‘foreign’. Since the nominal exchange rate, \(e\), between Spain and Germany is 1, Spain’s real exchange rate relative to Germany simplifies to:

\[c = \frac{1 \times P^*}{P} = \frac{P^*}{P}\]

—that is, the price, \(P^*\), of German goods and services relative to the price, \(P\), of those produced in Spain, both measured in euros.

Then if, for example, inflation is higher in Spain than in Germany, the price of Spanish goods and services rises relative to German prices. Since Spanish goods become relatively more expensive, Spain’s competitiveness, \(P^*/P\), falls, or in other words, its real exchange rate appreciates—even though the nominal exchange rate is fixed.

Competitiveness will only remain unchanged if prices in euros in the two countries rise at the same rate. For example, if inflation in both countries is 2%, both \(P\) and \(P^*\) go up by 2% per annum and competitiveness stays constant.

Fix regime: Impact of a country-specific demand shock within a common currency area

What happens if Spain, as a member of the eurozone, is hit by a country-specific shock that raises aggregate demand—such as a housing boom?

Figure 7.5 shows that in a benchmark FlexIT economy, the home country’s central bank would raise the interest rate in response to such a shock and that appreciation of the nominal exchange rate would reinforce the impact of monetary tightening. But the Bank of Spain cannot use the interest rate as a policy tool. When Spain entered the eurozone, control over this tool was handed over to the European Central Bank. The ECB would not be doing its job properly if it responded to something that affected the Spanish economy but had no effect on inflation elsewhere in the eurozone. The exchange rate of the euro against other currencies is not fixed, but if the ECB is holding monetary policy constant, we would not expect that to change either.

However, the real exchange rate can still play a major role in stabilizing shocks that only affect one eurozone member country. As in the benchmark case of the FlexIT economy, an appreciation in the real exchange rate depresses the country’s net exports and offsets the rise in aggregate demand. In a FlexIT economy, this happens rapidly because the nominal exchange rate appreciates when the central bank raises the interest rate. But since Spain’s nominal exchange rate is fixed, its real exchange rate adjusts only slowly following the country-specific demand shock, through changes in its inflation rate (via wage and price changes). Work through Figure 7.11 to understand how this happens.

To summarize: Figure 7.11 tells us that when the demand shock stimulates domestic inflation in only one member country, there is no response to reverse this through a rise in the policy interest rate because monetary policy is turned off. Over the course of time, through successive rounds of wage and price setting, sustained higher domestic inflation will mean that home’s real exchange rate will appreciate, and therefore progressively worsen its net exports, \(X – M\). This will eventually offset the impact of the positive demand shock.

Hence, there are significant contrasts, but also important similarities, with the FlexIT economy.

• FlexIT economy: The reversal of aggregate demand can be quite rapid. The central bank’s increase in the policy interest rate immediately causes an appreciation of home’s nominal exchange rate. Foreign exchange markets respond quickly to changes in the interest rate. Prices respond more slowly, so for given values of \(P\) and \(P^*\), this would also imply a real appreciation, offsetting the impact of the demand shock.
• Common currency area (extreme case of a ‘Fix’ regime): Since home’s nominal exchange rate cannot change, the aggregate demand shock is only slowly offset as higher domestic inflation produces a gradual real appreciation. If, for example, we assume (as in Unit 4) that wages are set annually and prices update after the wage round, the process of real appreciation will be protracted.

If the demand shock is permanent, then Spain’s competitiveness will permanently worsen, and net exports will be permanently lower when equilibrium is restored. If the demand shock is temporary, then reversing the effects of the real appreciation on its net exports would require a real depreciation, which in turn requires Spanish inflation to be below German inflation for a protracted period. In the absence of other changes, this is likely to lead to a prolonged period of unemployment.

What determines long-run inflation in a common currency area?

We know from Unit 5 that in an economy with a stable inflation target (FlexIT), in the long run inflation will always converge back to the central bank’s target rate of inflation, with unemployment at the supply-side equilibrium.

What determines the long-run inflation rate of a country in the eurozone? The answer is that each member country’s inflation rate is ultimately determined by the inflation target of the European Central Bank.

To understand why, we again need to think about the real exchange rate.

We argued earlier that an economy can only be in supply-side equilibrium if its real exchange rate, or competitiveness, is constant. This condition applies equally to an economy, like Spain, within a common currency area.

In the previous section, we saw that constant competitiveness requires that the following condition must hold:

\[\text{Constant competitiveness} \Rightarrow \delta = \pi - \pi^*\]

In the context of a FlexNIT economy, we argued that—for a home economy with a higher inflation rate than the foreign economy (\(π > π^*\))—this must imply that the nominal exchange rate depreciates at a rate, \(\delta\), that offsets the impact on competitiveness.

In the context of a member of a common currency area, our ultimate Fix economy, we use the same expression but now the causation runs in the opposite direction. Fixing the nominal exchange rate irrevocably means that, by definition, \(\delta\) must be zero. Therefore:

\[\text{Constant competitiveness in a common currency area} \Rightarrow \pi = \pi^*\]

which, if Spain is the home economy, means that Spanish prices must be growing at the same rate as prices in the eurozone as a whole. Here, \(^*\) indicates the eurozone.

In other words, to reach long-run equilibrium, Spanish inflation, \(π\), must converge to average inflation in the eurozone, \(π^*\). We have already argued that the eurozone itself, taken as a whole, can be viewed as a FlexIT economy, with monetary policy set by the ECB, and an exchange rate for the euro that is fully flexible and which fluctuates against other major currencies. We show in Unit 5 that in any FlexIT economy, the ultimate determinant of the inflation rate is the target rate of the central bank. So if the ECB is doing its inflation-targeting job, \(π^*\) will converge to its target inflation rate, \(π^T_\text{ECB}\).

Therefore, the long-run rate of inflation for any individual country that is a member of the eurozone (like Spain) is:

\[\pi = \pi^* = \pi^T_\text{ECB}\]

While this condition will hold on average over the long term, it will not hold at every point in time. Specifically, as illustrated in Figure 7.11, for as long as the home economy (like Spain) is away from its supply-side equilibrium, its inflation rate will be different from the ECB’s target rate, and its real exchange rate will not be constant.

So why join a common currency area?

By now you may be wondering: why would a country like Spain join the eurozone, and thereby adopt the most extreme case of the Fix regime? The arguments so far seem to suggest that it compares unfavourably with the FlexIT regime. While movements in the real exchange rate do have a stabilizing effect on a Fix economy, these operate more slowly than in a FlexIT regime. And while inflation is stabilized, at least over the long term, at the target rate set by the ECB, the Spanish government does not get to choose this rate. Its monetary policy is entirely dependent.

Why not have a FlexIT regime instead? One reason is that the successful operation of monetary policy in a FlexIT regime relies on the credibility of the government’s commitment to the independence of the central bank. Unless the government can make a credible commitment to delegate monetary policy fully and permanently, and set a stable inflation target, a common currency zone will tie its hands more securely.

Another argument for joining a common currency area relates more to microeconomics than macroeconomics. Within any given country, we take it for granted that all regions use the same currency. Different currencies would be inconvenient (and costly) for interregional trade of goods and services. The same logic applies to a group of countries that have a lot of cross-border trade, and is a key motivation for the formation of a common currency area.

In comparison with a FlexNIT regime, the balance of arguments is much more favourable. Without the discipline of an independent central bank with a stable inflation target, inflation in a FlexNIT economy can easily drift upwards. Inflation can also drift up for a eurozone member, but only temporarily, given that it brings with it a real appreciation. In the long run, inflation for a eurozone member country will be pinned down by the ECB’s target rate, so membership of the eurozone rules out any sustained upward drift in the inflation rate.

An example: Real exchange rate changes and the impact on the Spanish economy after joining the eurozone in 1999

The processes we have described in this section are not just theoretical. The evidence shows that something very similar did happen to Spain in the years after it joined the eurozone. Figure 7.12 tells the story with reference to data on Spain and Germany.