The summit adopted changeover recommendations presented in a 1995 European Commission Green Paper and a report by the European Monetary Institute (the forerunner of the European Central Bank). On the basis of economic and financial indicators of “convergence” (including budget deficits, ratios of debt to GDP, interest rates and inflation rates), initial participants were selected in early 1998. Eleven countries that wanted to join were deemed to have qualified. Britain and Denmark decided to opt out. Greece and Sweden were deemed not to have qualified. Greece was admitted from January 1st 2001. Slovenia, Cyprus, Malta and Slovakia joined subsequently (see Table 11.4).
Table 11.4 Permanent conversion rates against euro area currencies
On January 1st 1999 the exchange rates of the 11 countries were irrevocably fixed. The euro replaced the ecu at a rate of one to one. On January 1st 2002 euro notes and coins were introduced. National currency notes and coins were withdrawn from circulation two months later.
Official interest rates in the 16 euro area countries are now set by the European Central Bank. The governors of the national central banks and six members of the Executive Board sit on the ECB’s rate-setting governing council.
Effective exchange rates
Measures: Average exchange rate against a basket of currencies.
Significance: Shows overall exchange-rate movements.
Presented as: Index numbers.
Focus on: Trends.
Yardstick: An increase indicates a strengthening currency. Movements of more than a few percentage points a year can be destabilising.
Released: Daily or monthly.
Overview
An effective exchange rate (EER) measures the overall value of one currency against a basket of other currencies. Changes indicate the average change in one currency relative to all the others.
Effective exchange rates are weighted averages of many currency movements with weights chosen to reflect the relative importance of each currency in the home country’s trade. For example, if the dollar appreciates by 10% against the Japanese yen but is unchanged against all other currencies, and if the yen accounts for 25% of American trade, the dollar’s effective exchange rate has risen by 2.5%.
For obvious reasons EERs are sometimes known as trade-weighted exchange rates. There are many ways of selecting the weights, based on imports of manufactured goods, total trade, and so on.
MERMs
Most indices use weights from the IMF’s multilateral exchange-rate model (MERM). This tries to measure the effect of exchange-rate changes on prices of exports and imports, and the response of trade flows to such price changes.
Main sources
The IMF, the major central banks and some other organisations calculate effective rates for all the major currencies. The Bank of England indices published on The Economist’s website and some daily newspapers for non-euro area countries are based on the IMF’s model. The IMF publishes monthly indices for most countries including euro area members.
Table 11.5 Effective exchange rates
Interpretation
If, for example, the effective exchange rate for the dollar rises by 1%, this indicates that the various exchange-rate changes that have taken place are the same as a flat 1% rise in the dollar against every individual currency. In other words, the observed movements will have the same effect on the American trade balance as a 1% overall rise in the dollar.
Effective exchange rates do not take account of inflation so they do not reveal anything about changes in a country’s competitiveness (see Real exchange rates below).
11.2 Effective exchange rates
Sources: IMF, Eurostat
Real exchange rates; competitiveness
Measures: International competitiveness.
Significance: Indicative of a country’s ability to sell abroad and of net price (inflation and exchange rate) pressures on the balance of payments.
Presented as: Index numbers.
Focus on: Trends.
Yardstick: The lower the index, the more competitive the country.
Released: Monthly, one month in arrears.
Overview
The international competitiveness of goods and services produced in a country depends on relative movements in costs or prices after adjusting for exchange-rate movements. For example, if prices increase by 4% in Germany and 6% in America, American competitiveness appears to have fallen by 2%. However, if over the same period the dollar fell by 3%, overall American competitiveness has actually improved by 1%. Such measures of overall competitiveness are known as “relative costs or prices expressed in a common currency” or, more simply, real exchange rates.
Indicators of prices and costs
There is no ideal measure of competitiveness. Those in common use are listed in Table 11.6 above. They are described in terms of America, but the calculations are the same for any country.
Table 11.6 Real effective exchange rates Relative normalised unit labour costs, period averages, 2005 = 100
Relative export prices
American export prices divided by a weighted average of competitors’ export prices, all expressed in a common currency. This might seem to be a logical basis for assessing price competitiveness but there are several drawbacks. Such an exchange rate covers only goods that are traded; it does not take account of competition between imports and domestic production in home or overseas markets; it measures orders but ignores unsuccessful quotations; and it fails to take account of profitability (exporters in general are price-takers; they may be forced to absorb exchange-rate movements in profits).
11.3 Real effective exchange rates
Sources: IMF; Eurostat
Relative export profitability
American export prices divided by American producer prices. This is not a measure of international competitiveness, but it is a useful supplement to relative export prices. It indicates the extent to which changes in export prices reflect changes in the profit margins on exports against home sales. If export prices rise less rapidly than domestic prices, export profitability has declined.
Import price competitiveness
American producer prices divided by American import prices. This provides a guide to import competitiveness, but again it ignores relative profitability.
Relative producer prices
American producer prices divided by a weighted average of competitors’ producer prices. This compares home prices with prices that they will be competing against overseas. It tends to overemphasise domestic markets.
Relative consumer prices
American consumer prices divided by a weighted average of competitors’ consumer prices. This ignores capital and intermediate goods, but it is good for comparing relative consumer purchasing power.
Relative GDP value-added deflators
The American GDP deflator divided by a weighted average of competitors’ GDP deflators. This is the most comprehensive basis for comparison, covering unit labour costs and profits per unit of output. One drawback is that some of the items in GDP are not traded, although it might be argued that inflation pressures are ultimately transmitted uniformly through all goods and services. Another problem is that the deflators are available only after a sizeable lag.
Relative unit labour costs
An alternative to price competitiveness is to look at cost competitiveness. This has the advantage of covering all industries: exporters, potential exporters and those competing with imports. However, because of a lack of data the only sensible indicator is relative unit labour costs (or ULCs – say, American ULCs divided by a weighted average of competitors’ ULCs, all in a common currency). This excludes profits and prices of materials.
Normalised relative unit labour costs
These are relative unit labour costs adjusted to allow for short-term deviations in productivity from long-term trends. This smooths out differences in the cyclical position of the countries being compared, but because of the difficulties of adjusting productivity
for the cycle it should be treated with care.
Interpretation
Common practice
Relative unit labour costs in manufacturing and relative export prices are the most popular measures, partly because they are available quickly and easily. However, rather than relying on just one indicator it is a good idea to look at several to get a feel for “average” changes.
The indicators are expressed in index form. The index rises if domestic costs or prices increase faster than foreign costs or prices. Thus a larger index number (stronger real exchange rate) indicates that the home country is less competitive. The broad implication is that to restore competitiveness, the currency must weaken or domestic prices/costs will have to increase less than foreign prices/costs.
Current international practice uses 2005 as a base for index numbers.
The indices do not take account of non-price factors (product differentiation) such as quality, reliability and design.
Terms of trade
Measures: The ratio of export prices to import prices.
Significance: Measures the volume of imports that can be bought with one unit of exports.
Presented as: Index numbers.
Focus on: Changes in the index.
Yardstick: An improvement indicates that export earnings will buy more imports – but the trade balance may worsen.
Released: Monthly.
Overview
The terms of trade indicate the purchasing power of a country’s exports in terms of the imports that they will buy.
Favourable or unfavourable
The terms of trade are said to improve if export prices rise more rapidly or fall more slowly than import prices. For example, if export prices rise by 5% and import prices rise by 2%, a given volume of exports buys roughly 3% more imports; the terms of trade have improved by 3%.
Common terminology suggests that movements in the terms of trade are “favourable” or “unfavourable”. However, after an “unfavourable” movement in the terms of trade, the trade balance will tend to improve (the smaller rise in export prices than import prices means that exports are more competitive), while a “favourable” movement in the terms of trade may price exporters out of the market and result in a weaker trade balance (see Trade balance and Exchange rates, pages 143 and 154).
Which way is up?
Governments usually define the terms of trade as export prices divided by import prices expressed in index form. A rise in the index indicates an improvement in the terms of trade: one unit of exports will buy more imports. Academics sometimes do it the other way around, as import prices divided by export prices. The lower the number, the fewer exports needed to obtain one unit of imports. The message is the same in both cases, but you need to check the basis for the calculation before you can interpret the numbers.
Unit value or average values
Terms of trade indices constructed using import and export unit value indices (see Export and Import prices, page 210) are not affected by changes in the commodity breakdown of imports or exports. Terms of trade indices based on average value indices reflect changes in composition as well as changes in prices.
In general unit values are most commonly used and are a satisfactory basis for the terms of trade, but where there has been a structural shift in the composition of trade, average value indicators are better. For example, if a country imported a larger proportion of oil in 1990 than in 2000 and if oil prices rise, a unit value terms of trade indicator based on 1990 weights will overstate the deterioration in the terms of trade. An average value indicator will show a smaller, more realistic, deterioration.
Devaluation or depreciation
Typically, an exchange-rate devaluation or depreciation increases import prices relative to export prices and causes the terms of trade to deteriorate.
Chapter 12
Money and financial markets
There have been three great inventions since the beginning of time: fire, the wheel and central banking.
Will Rogers
Money
The cornerstone of the modern economy is money, which is a measure of value, a medium of exchange and a store of wealth. It is also the bridge between real and nominal magnitudes, so understanding it is vital for understanding and controlling inflation.
Markets
Financial markets bring together the supply of savings and the demand for money to finance businesses and consumer spending. The markets also allow people to complete commercial transactions and spread risks. Note that there are two sides to every transaction: for every lender there is a borrower; for every seller, a buyer.
Interest rates
Interest rates are the price of money. They link large stocks of physical and financial assets with smaller flows of savings and investment; they connect the present and the future; and they are sensitive to inflation expectations. As a result they are very volatile and hard to predict. With all these factors at work, it is hardly surprising that there is no simple theory which explains why interest rates behave as they do.
Liberalisation and globalisation
Financial systems changed dramatically in the 1970s, 1980s, 1990s and 2000s. There were three main influences.
Liberalisation and deregulation. Exchange, credit and interest rate controls were abolished or relaxed in the major industrialised countries.
Innovation. Many new financial instruments and derivatives were introduced, including financial futures and options.
Technological change. Computers and modern telecommunications have allowed transactions to be completed quickly and cheaply.
As a result the world’s major financial markets have become much more integrated. A change in American, Japanese or euro area interest rates is felt immediately throughout the world, which means that domestic monetary policies are influenced by uncontrollable outside influences. Monetary variables are harder to control and the demand for money is less sensitive to domestic interest rates.
Key figures
The following briefs examine money and bank lending, interest rates, bond yields and share prices. They are all interlinked. Nevertheless, the exchange rate (see page 154) is also an important indicator of monetary conditions.
Money supply, money stock, M0 ... M5, liquidity
Measures: Notes, coins and various bank deposits.
Significance: Indicator of level of transactions and, perhaps, inflation or output.
Presented as: Money totals at a point in time, usually end-month; except averages of Wednesdays for Canada and daily averages for Japan and America.
Focus on: Changes over time.
Yardstick: OECD average narrow money growth was 7.4% a year during the period 2000–2008.
Released: Monthly; one month in arrears.
Overview
Money is anything which is accepted as a medium of exchange; essentially currency in circulation plus bank deposits. Notes and coin, issued by the monetary authorities (mainly central banks), account for only a tiny proportion of the money supply. The rest is bank deposits, which are initially created within the banking sector.
The total amount of money in circulation, the money stock or money supply depending how you look at it, is often called M. The number of times it changes hands each year is its velocity of circulation, V.
Multiply the two together (M × V) and you have the amount of money that is spent, which by definition must equal real output Y multiplied by the price index P; that is, M × V = Y × P.
This equation is the basis for understanding money. Assume for the moment that velocity is fixed or predictable (it is not particularly). In this case, argue the monetarists, controlling the money supply controls money GDP (that is, Y × P); and if the trend in real output Y can be predicted inflation can be controlled. Their opponents argue that cause and effect run in the other direction, that money GDP fixes the demand for money and there is nothing that can be done about it.
Whoever is right, if you are prepared to accept tha
t velocity is fixed in the short term, then as a dangerously crude rule of thumb, subtract the inflation rate from the rate of growth of money to estimate the growth of real output.
Money defined
Narrow money, M1
In most countries the measure of narrow money is called M1. This is fairly uniformly defined as currency in circulation plus sight deposits (accounts where cash is available on demand).
There are some national variations. Britain’s narrow money measure is called M0. This consists almost entirely of cash in circulation, but also includes banks’ operational deposits at the Bank of England. Britain has no M1 measure. America’s M1 measure includes travellers’ cheques. Japan’s definition includes the government’s sight deposits.
The number of national variations was reduced in the run-up to the creation of the euro, with the harmonisation of the definition of monet ary aggregates across the euro area. The European Central Bank publishes monetary statistics for the whole euro area from figures compiled by national central banks.
Broad money, M2
The main wider definitions of money are called M2 and M3. In essence, M2 consists of M1 plus savings deposits and time deposits (accounts where cash is available after a notice period). The definition of M3 is wider still.
In America M2 consists of M1 plus savings deposits, time deposits and retail money-market mutual funds.
In the euro area M2 is defined as M1 plus deposits with agreed maturity of up to two years plus deposits redeemable at up to three months’ notice.
In America M3 consists of M2 plus institutional money funds, large time deposits, repurchase agreements and Eurodollars.
In the euro area M3 equals M2 plus repurchase agreements, money-market funds and paper, and debt securities of up to two years’ maturity.
In Japan, the measure of broad money is M2 plus certificates of deposit. M2 consists of currency in circulation plus public- and private-sector deposits.
Guide to Economic Indicators Page 15
