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Chapter Twenty Alternative International Monetary Regimes © 2003 South-W estern/Thom son Learning

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Page 1: Chapter Twenty Alternative International Monetary Regimes

Chapter Twenty

Alternative International Monetary Regimes

© 2003 South-Western/Thomson Learning

Page 2: Chapter Twenty Alternative International Monetary Regimes

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Chapter Twenty Outline

1. Introduction

2. What Does a Monetary Regime Need to Do?

3. The Gold Standard, 1880-1913: Panacea or Rose-Colored Glasses?

4. The Interwar Years, 1945-1971: Search for an International Monetary System

5. Bretton Woods, 1945-1974: A Negotiated International Monetary System

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Chapter Twenty Outline

6. Post-Bretton Woods, 1973 — : Another Search for an International Monetary System

7. The Fixed-versus-Flexible Debate

8. Money in the European Union: from EMS to EMU

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Introduction

• The goals of this chapter are to:1. Examine the considerations that go into the

choice of a regime;

2. Outline some of the available alternatives other than fixed or perfectly flexible exchange rates; and

3. Evaluate the strengths and weaknesses of alternative regimes, as well as the historical experience under each.

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What Does a Monetary Regime Need to Do?

• An international monetary regime should:1. Promote efficient functioning of the world

economy by facilitating international trade and investment.

2. Support international borrowing and lending.

3. Promote balance-of-payments adjustment to prevent the disruptions and crises associated with large, chronic BOP imbalances.

4. Provide countries with liquidity sufficient to finance temporary BOP deficits.

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What Does a Monetary Regime Need to Do?

• An international monetary regime should:5. Avoid adding to uncertainty, which may

discourage international transactions and cause countries to forgo gains from trade.

6. Embrace policy effectiveness and provide policy makers with a number of instruments at least equal to the number of targets.

7. Minimize the possibility of policy mistakes and cushion their negative impact.

8. Generate confidence in the stability and continuity of the monetary system.

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What Does a Monetary Regime Need to Do?

• An international monetary regime should:9. Strive to continue to lower the administrative and

operating costs of doing business in a monetary system.

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The Gold Standard, 1880-1913

• What is a gold standard?– Gold evolved to function as money as national

governments assumed larger roles in the money-supply process.

• Gold coins became popular, because it eliminated the need to weigh and measure at each transaction.

• As economies grew and the number and size of economic transactions increased, the use of currency or paper money as a substitute for gold began to spread.

– Currency was convertible: holders could convert it into gold on request, and vice versa.

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The Gold Standard, 1880-1913

• This type of gold standard, in which currency backed by gold circulated as the money stock, evolved independently in many countries.– Most major countries used gold standard by 1880.– Simple rules governed the gold standard:

• Each government defined the value of its currency in terms of gold: Two countries defined the mint exchange rate between their two currencies.

• Rate established by private arbitrage and government purchases and sales of gold to keep each currency fixed in terms of gold.

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The Gold Standard, 1880-1913

• How is a gold standard supposed to work?– Primary arguments in favor of gold standard rest

on the belief that the system contributes to price stability (avoiding inflation) and contains an automatic adjustment mechanism for maintaining BOP equilibrium.

• Gold standard imposes price discipline on central banks: keeps them from creating continual increases in the price level through excessively expansionary monetary policy.

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The Gold Standard, 1880-1913

• Specie: term for money in the form of precious metals.– The gold standard system’s automatic adjustment

mechanism was David Hume’s specie-flow mechanism for solving balance-of-payments problems through symmetric changes in the relative sizes of countries’ money stocks.

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The Gold Standard, 1880-1913

• How did the gold standard really work?– Was the pattern of gold stock growth smooth

(would it help to prevent economic shocks)?• It was actually quite volatile.

– Did governments actually abide by the rules?• Studies suggest that policy makers often disregarded the

rules – changed laws to require less gold backing of currency.

– Gold-standard era exhibited greater instability in terms of money growth, prices, and real output than some analysts admit.

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The Gold Standard, 1880-1913

• How did the gold standard really work (continued)?– Had limited success due to two reasons:

1. Gold stock itself grew erratically due to new discoveries, new extraction technologies, and changing incentives for mining.

2. Unless inclined to abide by the restrictions placed on money growth by the gold stock, central banks could circumvent the rules and eliminate much of the discipline credited to the gold standard.

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Search for an International Monetary System, 1919-1939

• The first World War caused many countries (not the U.S.) to abandon the gold standard.– Needed funds to pay for war efforts.– Ushered in new era of flexible exchange rates.

• Fixed mint exchange rate system disappeared.

– Produced high rates of inflation in most economies.

• Most policy makers recognized a return to prewar rates as infeasible.

• Germany printed massive quantities of money

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Search for an International Monetary System, 1919-1939

• The Great Depression came in 1931.– Interwar period characterized by pervasive

political and economic instability.• Spread of trade restrictions.

• Beggar-thy-neighbor trade policies.

• Major economies were determined to unite to build a stable and open monetary system after WWII.

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Bretton Woods, 1945-1971

• Bretton Woods reinstated fixed exchange rates with three changes:1. New regime was a gold-exchange standard: a

national currency – the U.S. dollar – played a central role along with gold.

2. New system was an adjustable-peg system rather than fixed: provided for altering exchange rates under certain conditions.

3. System created the International Monetary Fund (IMF) as a multilateral body to facilitate the success of the new agreement.

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Bretton Woods, 1945-1971

• What is a gold-exchange standard?– Non-dollar currencies were not convertible directly

into gold.• They were convertible, at a pegged exchange rate, into

dollars called the key, or reserve currency), which in turn were convertible into gold at $35 per ounce.

• U.S. responsibilities:

1. Stand ready to sell or buy gold in exchange for dollars at $35 per ounce on request of other central banks; and

2. Create no more dollars subject to convertibility than the U.S. stock of gold could support.

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Bretton Woods, 1945-1971

• How was Bretton Woods supposed to work?– Three important elements attempted to introduce

flexibility to address domestic macroeconomic priorities for which electorates increasingly held governments responsible:

1. The Adjustable Peg

2. IMF Lending Facilities

3. Exchange and Capital Controls

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The Adjustable Peg

– The Adjustable Peg• System of fixed exchange rates that embodies

rules for the periodic adjustment of rates as economic conditions change.

• Fundamental disequlibrium: when economic circumstances change permanently or dramatically such that the pegged rate clearly differs from long-run equilibrium.

• Policy makers could change the pegged rate.

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IMF Lending Facilities

2. IMF Lending Facilities– IMF loans reserves (either gold or foreign currencies) to

governments with temporary BOP deficits, but for whom immediate monetary contraction presents unacceptable domestic economic consequences.

– Each member country contributes a sum (their quota) consisting of 25% gold and 75% domestic currency.

– Country’s routine borrowing privilege based on their quota.

– IMF divided each country’s borrowing privileges into several classes called tranches.

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IMF Lending Facilities

• Conditionality referred to the IMF’s requirement that countries follow certain policy prescription as condition for borrowing

– Most common conditions:• Adjusting exchange rate.• Lowering deficit spending by government.• Lowering money-supply growths.

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Exchange and Capital Controls

3. Exchange and Capital Controls• Bretton Woods agreement avoided requiring

convertibility of capital-account or financial transactions.– Rationale? Private capital flows across borders

added too much instability to the world’s economy.

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Bretton Woods, 1945-1971

• How did Bretton Woods really work?– Credibility of Bretton Woods system tied to two

commitments:1. Tying countries’ currencies to the dollar; and

2. Tying the dollar to gold.

– As shown in Figure 20.1, dollar liabilities to foreign central banks surpassed the U.S. gold stock in 1964.• 1971: U.S. left gold standard – no more conversion at

$35/oz.

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Bretton Woods, 1945-1971

– Gold moved up in value.– New agreement replaced Bretton Woods: The

Smithsonian Agreement, which differed in one major way:

• The U.S. made no promise to convert dollars into gold at the new $38 rate – the old gold-dollar standard had now become a dollar standard.

– By 1973, most currencies of industrialized countries floated against the dollar.

See Figure 20.1See Figure 20.1

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Figure 20.1: U.S. Gold Stock & Dollars Eligible for Conversion to Gold During Bretton Woods

70

0

10

20

30

40

50

60

1948 50 52 54 56 58 60 62 64 66 68 70 1972

U.S. gold reserves

U.S. liabilities

Year

U.S. Dollars (Billions)

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Bretton Woods, 1945-1971

• Bretton Woods system met with difficulties for three basic reasons:

1. U.S. responsibilities under the system sometimes conflicted, so at least some of them were not carried out.

2. Central banks faced a dilemma between their international responsibilities under the agreement and the macroeconomic policies acceptable to their domestic political constituencies.

3. As capital mobility increased, potential conflicts between a country’s global and domestic obligations could quickly trigger a capital outflow and a BOP crisis whenever market participants began to expect a devaluation.

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How Did the Macroeconomy Perform under Bretton Woods?

• World economy performed respectably during this period.– U.S. output grew.– Rapid growth in world trade and investment.– Inflation not a problem during early years – bigger

threat later as U.S. expansionary policies produced price increases.

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Post-Bretton Woods, 1973 -

• The system in use today by the major industrialized economies is a managed float:– Refers to a system in which the forces of supply

and demand in foreign exchange markets determine basic trends in exchange rates, but central banks intervene when they perceive markets as “disorderly” or dominated by short-term disturbances.

• Some opponents call this a dirty float, referring to the fact that central banks’ intervention actions dirty, or interfere with, market forces.

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Post-Bretton Woods, 1973 -

• How is a managed float supposed to work?– It aims to limit exchange rate uncertainty by using

intervention in FX markets to eliminate short-run fluctuations in exchange rates.

• At the same time, managed float allows market forces to determine long-run exchange rates, breaking the link between the balance of payments and the money stock and preventing chronic payments disequilibria.

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Post-Bretton Woods, 1973 -

• How is a managed float supposed to work?– Figure 20.2 illustrates the responses to permanent

and temporary changes in demand under a managed float:

• In panel (a), the demand for pounds increases permanently.

– The response is to allow the exchange rate to move to a new equilibrium.

• In panel (b), the demand for pounds increases temporarily, but then moves back down to the original level.

– Intervention would hold the exchange rate at its fundamentally equilibrium level.

See

Figure

20.2

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Figure 20.2: Response to Permanent & Temporary Changes in Demand under Managed Float

(a) Permanent Increase inDemand for Pounds

e = $/£

e1*

0

e0*

D1 = D2

D0

(b) Temporary Increase inDemand for Pounds

e = $/£

e1*

0

e0*

D1

= D2D0

£ £

£

£

£ £

££

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Post-Bretton Woods, 1973 -

• What are the problems with a managed float?– Figure 20.3 illustrates the dilemma of a managed

float: to intervene or not to intervene?• One interpretation of the “rules” of a managed float is

to intervene in response to a temporary disturbance in FX markets and to avoid intervention in response to permanent changes in underlying exchange rate.

– A practical difficulty arises because at the time of the disturbance (t0), a policy decision must be made, but policy makers cannot know the precise nature of the disturbance.

See Figure 20.3See Figure 20.3

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Figure 20.3: The Dilemma of a Managed Float: To Intervene or Not to Intervene?

e = $/£

Time

I

II

0 t0

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Post-Bretton Woods, 1973 -

• What are the problems with a managed float?• Reviewing Figure 20.3, it should be noted that, in

practice, central banks often intervene just enough to dampen or slow down the exchange rate movement, but not enough to stop it completely.

– These types of policies are called leaning against the wind.

• A managed float does not change the basic rule that correction of a payments imbalance requires a change in either the exchange rate or the money stock.

– When banks engage in sterilized intervention to circumvent this basic rule, crises develop.

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Post-Bretton Woods, 1973 -

• How has the macroeconomy performed in the post-Bretton Woods years?

• Years since 1973 represent a period of widely varying degrees of management of exchange rates.

• Analysts remain divided over the managed floating exchange rate system:

– One camp worries about exchange rate volatility, the resource-allocation effects of unpredictable changes in real exchange rates, and lack of effective policy coordination among U.S., Germany, and Japan.

– Most acknowledge both the difficulties of returning to a fixed rate system and governments’ reluctance to subordinate domestic economic interests to the requirements of external balance, as demanded by a fixed rate regime.

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The Fixed vs. Flexible Debate

• Pros and cons of fixed exchange rates:1. Price discipline

– Not entirely effective in preventing inflation.

2. Reduced volatility and uncertainty– Volatility and uncertainty may discourage beneficial

global economic activity by making domestic-currency value of future receipts and payments less certain;

– Can also cause costly movement of resources as hard-to-predict exchange rate changes alter relative prices and shift demand back and forth between domestic and foreign goods.

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The Fixed vs. Flexible Debate

• Pros and cons of fixed exchange rates:3. Real exchange rate adjustment

• Opponents say that devaluations occurred too infrequently under Bretton Woods.

• Also noted that fixed system required countries to hand control of their money over to the U.S.

4. Exchange crises– Fixed system builds confidence in stability of rates.

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The Fixed vs. Flexible Debate

• Pros and cons of flexible exchange rates:1. Crisis avoidance

– Tends to avoid the large disturbances.

2. Policy independence and symmetry– Allows each country to determine its own monetary

policy.– Can also choose their own inflation rates.

3. Consistency with capital mobility– Must be able to convince market participants that

devaluation is not planned…otherwise, capital will flow out.– Some countries instill capital controls – hurts

economic efficiency.

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The Fixed vs. Flexible Debate

• Pros and cons of flexible exchange rates:4. Excessive volatility and real exchange rates

– Flexible rates sometimes produce unacceptable volatility.

– Difficult to predict and control.

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The Fixed vs. Flexible Debate

• Insulation from economic shocks– Three major classes of shocks that disturb

economies and demand responses from policy makers:1. Demand shocks that originate in the money market;

2. Demand shocks that originate in spending patterns; and

3. Supply shocks.

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The Fixed vs. Flexible Debate

• Insulation from economic shocks– Shocks to domestic money market

• Fixed systems tend to provide more insulation.

• Flexible systems provide some insulation against foreign monetary disturbances, but only in the long run.

– Shocks to spending on domestic goods and services.

• Flexible rates tend to provide more insulation.

• Fixed rates can cause additional problems (lower output or capital outflow).

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The Fixed vs. Flexible Debate

• Insulation from economic shocks– Supply shocks

• Flexible rates provide policy makers with more choices in their responses.

• Fixed rates constrain policy makers to pursue macroeconomic polices consistent with BOP equilibrium.

– Cannot use expansionary monetary policy as temporary device to cushion the shock.

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Money in the European Union

• History, 1979-99– Since 1979, most EU members have been fixed relative

to one another and floated as a group against the dollar.

• Called the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS).

– Weighted basket or composite of EU currencies called the European Currency Unit (ECU) floated against non-EU currencies.

– Within the ERM, each central bank intervened in foreign exchange markets to keep value of its currency fixed within a prescribed band against the ECU.

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Money in the European Union

• History, 1979-99 (cont.)– Proponents of European monetary integration

hoped to accomplish several goals:1. Improve European economic performance;2. Rival the U.S. as a more nearly equal macroeconomic

counterpart in global negotiations;3. Would encourage intra-European trade and investment

by lessening exchange rate fluctuations;4. Establish sound policies in those countries that lacked

credible institutions (Italy and Greece); and5. Would contribute to the momentum toward more unified

policy making in Europe.

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Money in the European Union

• Maastricht, monetary unification, and crisis.– 1991 in Maastricht, Netherlands: EU

governments signed agreement which outline plans for an economic and monetary union (EMU):1. Irrevocable fixing of exchange rates leading to

introduction of a single currency;

2. Single monetary policy; and

3. Single exchange rate policy.

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Money in the European Union

• Proponents of Maastricht Plan wanted to accomplish two goals:1. By creating a common currency, minimize

transaction costs and establish a stable exchange rate system not susceptible to crises generated by expected currency realignments; and

2. By creating a European system of central banks, give other EU countries a voice in monetary policy, dictated largely by Germany under the pre-Maastricht EMS arrangements.

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Money in the European Union

• Timetable at Maastricht required ratification by all 12 member countries.– Denmark voted NO in 1992.– Also in 1992: Italy and Britain withdrew from the

ERM and Spain devalued the peseta.• Denmark and Britain, in exchange for their ratification

of Maastricht, won the rights to “opt out” of its provisions for a common European currency.

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Money in the European Union

• Crises followed after 1992.– Several currency realignments.– German reunification caused many monetary

problems.– Most European countries found themselves in

recession.

• 1995: EU members voted to proceed with monetary unification.– New currency would be the Euro.

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Money in the European Union

• Maastricht convergence indicators.– Maastricht treaty required each EU member to

meet 5 economic convergence criteria before it could participate in monetary unification:1. Currency must remain within ERM trading bands for

2 years with no realignment.2. Inflation for preceding year must have been no more

than 1½% above the average inflation of the 3 lowest-inflation EU members.

3. Long-term interest rate on government bonds during preceding year must have been no more than 2% above average rate of 3 lowest-inflation EU members.

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Money in the European Union

4. Budget deficit must not exceed 3% of country’s GDP.

5. Government debt must not exceed 60% of country's GDP.

• Of the 15 EU members, Denmark, Sweden, and Britain opted out of participation in the monetary union.– Of remaining 12, only Greece did not qualify.

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Money in the European Union

• Who should use a common currency?– Mundell developed theory of an optimal currency

area in the early 1960s: the area that maximizes the benefits minus the costs of using a single currency.

– Potential benefits of common currency:• Reduced exchange rate volatility;

• Reduced transaction costs; and

• Enhanced policy credibility.

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Money in the European Union

• Costs of a common currency:– Countries lose the ability to pursue independent

monetary policies.– Common currency eliminates exchange

devaluations or revaluations as a policy tool within the currency area.

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Money in the European Union

• How does an area decide whether a currency area would provide net benefits?– Region is likely to gain from a common currency

if:1. A large share of the members’ trade occurs with other

members;2. The region is subject primarily to common shocks that

affect the entire area similarly and not to shocks that affect its subregions differentially;

3. Labor is mobile within the regions; and4. A tax-transfer system exists to transfer resources from

subregions performing strongly to those performing poorly.

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Money in the European Union

• Comparison of EU and U.S. :– EU appears more subject to differential shocks.– Labor is considerably less mobile between

countries in Europe.• In fact, labor is less mobile even within countries in

Europe than in the U.S.• Greater language and cultural differences in EU.

– EU countries have no supranational tax and transfer system to reallocate resources across regions in response to shocks.

• EU does administer some development funds for less-developed regions.

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Money in the European Union

• In the end, two considerations will play central roles in the success or failure of the European monetary union:1. EU needs to undertake structural reform to

improve flexibility of labor markets and to reduce the size of their welfare policies; and

2. Countries must prove willing to subordinate their national policymaking sovereignty to the EU.

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Key Terms in Chapter 20

• Convertible currency

• Gold standard

• Mint exchange rate

• Price discipline

• Specie-flow mechanism

• Gold-exchange (gold-dollar) standard

• Key (reserve) currency

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Key Terms in Chapter 20

• Adjustable-peg system

• Fundamental disequlibrium

• Tranches

• Conditionality

• Liquidity

• Dollar standard

• Managed (dirty) float

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Key Terms in Chapter 20

• Leaning-against-the-wind policies

• Exchange Rate Mechanism (ERM)

• European Monetary System (EMS)

• European Currency Unit (ECU)

• Economic and monetary union (EMU)

• Euro

• Convergence indicators

• Optimal currency area