UNIT 16.

INTERNATIONAL CAPITAL
MOBILITY AND THE EMERGING
MONETARY SYSTEM
Structure
16.0 Objectives
16.1 Introduction
16.2 Globalisation and Macroeconomic Management
16.3 Evolution of International Monetary System and its Present Status
16.4 Short-Term Capital Movements and East-Asian Crisis - Lessons for
Developing Countries
16.4.1 Impact of Crisis
16.4.2 Causes of Crisis
16.4.3 Role of the IMF
16.4.4 Lessons from the Crisis

16.5
16.6
16.7
16.8
16.9

Post-Maastricht Developments and Developing Countries

Let Us Sum Up
Key Words
Some Useful References
AnswersIHints to Check Your Progress Exercises

16.0 OBJECTIVES
After reading this Unit, you will be able to:
understand globalisation and macroeconomic management;
describe the evolution of the global financial and capital regime;
appreciate the nature, causes, impact and lessons fiom Asia1 crisis;
analyse the evolution of the international monetary system; and
derive the implications for the developing countries, especially after the
Maastricht Treaty.

16.1

,
I

I
I

!
1

INTRODUCTION

International capital mobility has depended to a large extent on the nature of

international financial system since the beginning of the Bretton Woods
system. In Unit 5, you learned about the GATT and the WTO; in Unit 8, about
the evolution of the internationhl monetary system; in Unit 9, about the Bretton
Woods financial institutions, the IMF and the World Bank; and in Unit 10,
about the debt crises in various developing countries in the 1970s and 1980s.
Given the fact that in present times, trade in goods and services are often linked
to capital flows like the FDI and portfolio as well as the global technology
regime it is important to understand the functioning of the erstwhile GATT and
the present WTO, governing global trade through multilateral rules. This is an
aspect often missed out in a discussion on international capital flows.
It would be noticed that the international monetary issues are dificult to
discuss in isolation fiom the exchange rate management issues. In other words,
the international monetary system has to be studied with the evolution of some
of the related international financial and macroeconomic issues. This Unit
therefore begins with a brief exposition of the standard IS-LM model for an
open economy with the possibility of capital flows. This is followed by a

' Theory of Region 0

review of the evolution of the international monetary system. It ib discernible

from the analysis that at present there is hardly any effective global monetary
system under any one single multilateral institution. Recent developments of
financial market integration and globalisation of capital flows have rendered
the monetary system quite fragmented in nature and it often lacks coherence.
On the other hand, they have increased the risk of contagion of crises. The
Asian currency crisis is dealt with at some length. This only calls for setting in
place a more strengthened international monetary and financial architecture. In
the last part of this Unit a brief account of the theory of optimal currency areas
is given, and post-Maastricht developments in the EU have been presented
along with some of their possible implications for the developing countries.

16.2 GLOBALISATIONAND MACROECONOMIC

MANAGEMENT
Closer integration makes both a qualitative and quantitative change in
economic decision-making. On the quantitative front, multipliers are smaller
(because of the larger 'leakage' into imports) so that government needs to
undertake larger policy actions either stimulatethe economy or to slow it down.
But it also means that a country is more readily affected by developments abroad.
So a government has not only to respond to domestic events, but also foreign
events including policy actions by governments of major countries and
partners.
~ualitativel~,
capital market liberalisation has significant effects on economic
management. Capital flows can have substantial destabilising effects. Most
governments need to supplement domestic savings to maintain a high rate of
investments and achieve higher growth. Policy makers have to become
cautious about the danger that outflow of foreign capital can generate.
Consequently, most governments are striving to maintain adequate level of
reserves. It is an open question whether it is good for poor country to hold such
large reserves on which they earn a very low return. Building up of reserves
means that either developing countries run a current account surplus, which
means they are actually lending to the developed countries or build up reserves
by borrowing for which they pay a higher interest rate. Therefore, in recent
years, developing countries have been borrowing but most of this borrowing
does not seem to have been used to boost the investment rate. Investment rates
in Africa and Latin America are lower
than they were in late 60s and 70s and
this lowering of investment rates has
contributed to reduced growth rates in
these regions.
Capital flows require a hdamental
change in policy-making. We discuss
how globalisation affects the ability of
monetary and fiscal policy to affect the
level of income. To examine this, we
use the conventional IS-LM
framework. You should revise your
basic macroeconomics and the BOP Ngum 16.l: M$ctdagmbmqdr#l
P
concats from Units 7 and 8. Suppose

the government adopts an expansionary fiscal policy, then the IS curve shifts
rightward from IS to IS'. This leads to an increase in the income and the
interest rate, as the equilibrium shifts from A to B (Figure 16.1). The increase
in income leads to higher imports and so to a worsening of the current account.
If there are no capital flows, the. worsening of the current account is also
worsening of the BOP. This, under a fixed exchange rate (ER) system, will
lead to a fall in foreign assets, a decline in the money base and in the money
supply. So the LM curve will shift leftward to LM' and the new equilibrium
will be at C. Here the original level of income and the current account is
restored. The higher interest rate implies that interest sensitive expenditures,
most importantly investments, are lower, namely have been crowded out by
the expansionary fiscal policy.

Internatlond cap~tal
Mobllity and the
Emerging Moneraty

If capital flows are permitted then because of the higher interest rate, capital
will flow in so that there is a capital account improvement and the worsening
of the BOP will be less and equilibrium could be at a point such as D where the
current account deficit is matched by a capital account surplus. The position of
D depends on the extent of capital mobility. If capital mobility is relatively
small, as at D, there will only be a small improvement in income. The greater is
the capital mobility, the greater is the increase in income and the smaller is the
rise in the interest rate. If there is perfect capital mobility, the country can
borrow any amount from the rest of the world at the going interest rate, which
will also determine the domestic interest rate, which must therefore be the
same as before the expansionary fiscal policy was implemented. The large
inflow of capital would imply a BOP surplus and an outward shift of the LM
curve to LM'" so that equilibrium is at E.
Suppose instead of a fixed ER, the
country has a flexible exchange rate. If
there are no capital flows, the BOP
deficit afterhe expansionarypolicy will
lead to a depreciation of the ER. This
will increase net exports if the
Marshall-Lerner-Robinson condition is
satisfied (as explained to you in Unit
8), so that the IS curve will shift further
to the right, to IS", leading to an
equilibrium at F where income and the
rate of interest are even higher (see
Figure 16.2).

--

~ ~ c ) l a a ~ b b ~ - ~

If, however, there are capital flows, the inflow of capital will limit the
depreciation, and so the rightward movement of the IS curve. With perfect
capital mobility, there will be a BOP surplus and the ER will appreciate
leading to a fall in net exports and hence a leftward shift of the IS curve.
Ultimately, equilibrium will be restored at the initial level of income and the
interest rate. In this case, the higher ER is crowding out exports to nullify the
expansionary fiscal policy.
Hence, the fiscal policy is more effective in the presence of capital flows when
the ER is fixed, but is ineffective when the ER is flexible.

System

Theory of Regional Blocs

Let us now examine the operation

of monetary policy. An
expansionarymonetary policy will
shift the LM curve rightward
leading to equilibrium at J in the
first instance (see Figure 16.3).
Here income is higher so that there
is current account deficit, and if
there are no capital flows, a BOP
deficit. Therefore, the country .
I
.163:
msll a d F'bdbDeRates
loses foreign exchange reserves to hlky
finance the deficit and money
supply shrinks until the original equilibrium is restored, so monetary policy
has no lasting effect on income. If, however, capital is mobile, there will be a
deficit on the capital account also as capital flows out due to downward
pressure on the domestic interest rate, so the LM curve will shift leftward faster.
With perfect capital mobility, the LM curve will not shift at all, because any
monetary expansion will lead to an equal outflow of foreign exchange. In this
case, monetary policy is completely ineffective in changing the income level.
This is often referred to as the impossible trinity - a country cannot
simultaneously have a fixed ER, free capital mobility and an independent
monetary policy.
If the ER is flexible, then with no capital mobility, the initial deficit will lead to
a depreciation and a rightward shift in the IS curve so that there is still higher
income. The depreciation will be still larger if capital is mobile as the capital
account is in deficit. So the IS curve will shift until equilibrium is restored at
the original interest rate, but at a higher level of income, say at point K.
Therefore, in a world with perfect capital mobility monetary policy is
ineffective in a fixed ER system and very effective in a flexible ER system.
Hence, whether to use fiscal policy or monetary policy to manage short-term
fluctuations depends on the extent of capital mobility.
0

Check Your Progress 1

1) What is the impact of capital mobility on fiscal policy?

2) Examine the impact of capital mobility on expansionary monetary policy.

International Capital
Mobility and the
Emerging Moneraty
System

16.3 EVOLUTION OF INTERNATIONAL

MONETRAY SYSTEM AND ITS PRESENT
STATUS

When a subject like the international monetary system is approached the first
question which arises is in terms of a definition of it as opposed to the
international financial system. The international financial system often includes
the monetary and exchange rate arrangements in its coverage. The
international financial system is defined as a set of global financial markets,
global financial institutions, official lenders such as the IMF, and global
regulatory arrangements.This set of institutions exists and has developed to
facilitate cross border transactions in financial instruments. In the present Unit,
developments in both monetary and financial matters would be taken up to
elucidate any important dimension of the global financial and monetary
systems'dynamics.

In economic theory, the interdependence of the international monetary system

stems from the fact that balances of payment are connected together. If one
country has a balance of payments surplus, the rest of the world has a balance
of payments deficit and vice versa. If one country has a balance of trade
surplus, the rest of the world has a balance of trade deficit. This has an
influence on the exchange rate system. In a world of n countries with n
currencies, there are n-1 independent exchange rates. No country can fix
exchange rates. There would be too many fixed exchange rates. There is one
degree of freedom, giving rise to what theorists called the redundancy
problem. The role of that extra degree of freedom was to maintain a stable
price level, or in the case of the gold standard, to maintain the price of gold.

With the rapid expansion of cross-border capital flows, the problem of what is
widely known as the "impossible trinity" came to the fore. As you learnt above,
it is impossible to achieve simultaneously the goals of a fixed exchange rate,
an open capital account, and a monetary policy dedicated to domestic
economic goals.
At this stage, the fixed exchange rate regime in various countries was dropped
as a goal worth pursuing. Before 1971, in the fixed rates regime, the IMFcould
defend and manage the anchored dollar system of fixed exchange rates. The
IMF lost its role as a guardian of the international monetary system since 1971
and especially after1973, the year the international monetary system moved
towards flexible exchange rates. The Fund was then shifted from its role at the
centre of the international monetary system to a new role of ad hoc
macroeconomic consultant and debt monitor. With the breaking down of the
gold exchange standard, which acted as a price-stabilisation mechanism through
the interdependence of the currency system, there was inflationary pressure
witnessed worldwide. Consequently, the Articles ofAgreement of the IMF were
amended in 1978 with a focus how on price stabilisation as imbibed in the
amended Article IV.
The factors that led to the breakdown of the 'Bretton Woods system were
discussed in Unit 8.3. To reiterate, in 1971, the United States decided to
de-link the dollar from gold. Regarding role of the Fund, it is amply clear that
the international mogetary system was being run by industrialised countries

25

T h e o ~ o Resional
f
Blocs

and not by the IMF, as envisaged. When the challenge of the transition
countries arose, the Fund had no coherent system for monetary stabilisation to
offer. An international monetary system in the strict sense of the world does
not presently exist. Every country has its own system.
There have been severe criticisms of the role and functioning of the IMF as a
global institution playing a developmental role. The credentials of the IMF
have been questioned by raising several issues including if IMF-supported
programs impose austerity on countries in financial crisis. Alternatively, we
may ask whether IMF-supported programs will facilitate bankers and elites.
Similarly, one may ask whether programs supported by IMF constrain spending
on priority sectors like education and health by "imposing" fiscal deficit limits.
On the other hand, is the IMF unaccountable?
These have given rise to various unique trends in the international monetary
system. These trends are fragmented and there is no one-umbrella institution,
which can be said to be providing an international monetary and financial
architecture, presently. These trends are summarised below:
domestic financial market deregulation and opening by countries since the
early 1980s
internationalisation of domestic financial markets and institutions
companies and financial institutions approach international capital markets
to raise needed funds
investors seeking investment opportunities abroad
countries allow foreign corporations and financial institutions to issue bonds
and stocks denominated in different currencies (including their own) in
their domestic financial markets and also allow foreign investors to buy
their domestic securities
emergence of other international financial centers located in Europe and
Asia along with the US bond and stock markets (the traditional international
capital markets)
growth of offshore money and capital markets such as the markets for
Eurobond etc.
integrated stock markets
rapid globalisation of banking, insurance, and other intermediatioil
businesses
large banks from the U.S, Europe, Japan etc. have global network of branches
and subsidiaries
Thus, the international capital market is not a single market. Instead, it refers to
a group of oflshore and onshore capital markets that are closely interconnected
to one another and in which domestic and foreign residents buy and sell many
different types of financial instruments. It is true of banking, insurance, and
other intermediation businesses as well.
I

Resultantly, the -growth of international capital flows has continued steadily in

recent decades. However, as their volume grew, the potential effects of reversals
became larger,, and countries dependent on such flows, primarily short-term
flows, became increasingly vulnerable to crises of confidence. In addition,
contagion, the spreading of crises from one country to another, due to financial
integration, has become a part of reality. That was evident not only in the Asian
crisis of 1997,but also in Latin Americaand Russia in 1998. What is important
such effects were felt even when economic fundamentals of the crisis-ridden
countries were strong. Nevertheless, at this stage, the role played by the IMF
\cannot be discounted and the crisis only pronounced the need for having a
strong global monetary and financial institution, which functions on
developmental imperatives more than bailing out countries fiom crisis. We
shall now explore the causes and consequences of the Asian crisis.

Check Your Progress 2

1) Point out the important dimensions of global financial and monetary
system.

2) What are the trends in the international monetary and financial system?

16.4 SHORT-TERM CAPITAL MOVEMENTS AND

EAST-ASIAN CRISIS - LESSONS FOR
DEVELOPING COUNTRIES
The global financial system evolved over the years in a manner in which
private capital flows took precedence over institutionalised flows fiom the
Bretton Woods system. One of the main recipients of such attraction from the
global capital market was the Asian region.
One of the reasons of such an attention was the economic dynamism displayed
by the Asian countires whose achievement was broadly acclaimed by economic
institutions including the IMF and World Bank,and was known as part of the
Asian economic miracle. This economic dynamism was reflected in countries
such as Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South
Korea that experienced high GDP growth rates of 8-12% in the late 1980s and
early 1990s. However, a debate on the success of the Asian countries got
initiated with Paul Krugman's article attacking the idea of an Asian economic

~ntemationdCapital
Mobility and the
Emerging Moneraty
System

Theory of Regionai Blocs

miracle in 1994 by arguing that it lacked long term sustainability. He argued

that East Asia's economic growth had historically been the result of capital
investment, leading to growth in productivity. However, total factor
productivity had increased only marginally or not at all. Krugman argued that
only growth in total factor productivity, and not capital investment, could lead
to long-term prosperity.
By 1997, Asia attracted almost half of total capital inflow to developing
countries. The economies of Southeast Asia in particular maintained high
interest rates attractive to foreign investors looking for a high rate of return. As
a result the region's economies received a large inflow of hot money (shortterm capital) and experienced a dramatic run-up in asset prices.
The Southeast Asian countires had large private current account deficits and
the maintenance of pegged exchange rates encouraged external borrowing and
led to excessive exposure to foreign exchange risk in both the financial and
corporate sectors. In the mid-1990s, two factors began to change their
economic environment. As the U.S. economy recovered from a recession in
the early 1990s, the U.S. Federal Reserve Bank began to raise U.S. interest
rates to combat inflation. This made the U.S. a more attractive investment
destination relative to Southeast Asia, which had attracted hot money flows
through high short-term interest rates. This step also raised the value of the
U.S. dollar, to which many Southeast Asian nations' currencies were pegged,
thus making Southeast Asian exports less competitive. At the same time, Southeast Asia's export growth slowed dramatically in the spring of 1996, due to a
glut in the international market (more countries exporting similar products),
deteriorating their current account position. Triggered by events in Latin
America, particularly afier the Mexican peso crisis of 1994, Western investors
lost confidence in securities in East Asia and began to pull money out, creating
a snowball effect. The Asian crisis started in mid- 1997 and affected currencies,
stock markets, and other asset prices of several Southeast Asian economies.
Further, the financial crisis led to an economy-wide crisis and in some coutries
even led to social and political problems.

16.4.1 Impact of Crisis

As mentioned, the impact of the financial crisis ranged from the financial and
banking spheres to general economic and social conditions. Some of the major
dimensions of the impact are surnmarised below.
Economic growth turned negative.
The currency devaluations exerted immediate upward pressure on the prices
of imported goods and services or goods with high import content.
Inflation generally increased (see Table 16.1).
Since food prices generally increased more rapidly than non-food prices,
the impact of inflation was harsher on the poor.
Inflation not only reduced purchasing power but along with the collapse
of stock markets and banks also drastically reduced the real value of
household savings.

Bankruptcies resulted in loss of savings and contributed to unemployment.

In terms of the social ~mpact,overall the unemployment rates increased in

all the countries affected by the crisis (see Table 16.2).
The informal labour force expanded with the entry of the unemployed from
the formal sector, resulting in lower earnings per worker.
The share of wage and salary incomes in total income declined, thereby
altering functional income distribution.
All these together led to increasing poverty levels. A common feature of
the crisis was that increases in poverty were greater in the urban areas than
in the rural areas.
Table 16.1: Impact of Crisis on Growth and Inflation

Source: ADB (1 999)

Table 16.2: Unemployment Rate (%)

16.4.2 Causes of Crisis

The causes of the crisis are often disputed. Overemphasis on excessive
financial and capital market liberalisation as opposed to generating real sector
activities have been considered as the root cause of the crisis. This led to
speculative capital of short term nature to flow into these countries and when
its outflow began it left the countries in a state of financial crisis. Due to capital
market integration while on one hand such rapid outflows were facilitated, on
the other hand, it also created the 'contagion effect' - crisis spreading from
one country to another.
Some economists have maintained that the main cause of the crises was
excessive real estate speculation and the mismatch between foreign currencydenominated borrowings and local currency denominated returns. While some
consider 'moral hazard' in the banking and financial system, others give more
emphasis to excessive speculation by short-term investors.

International Capital
Mobility and the
Emerging Monemty
System

Theory of Regional Blocs

Arguments of others have downplayed the role of the real economy in the
crisis compared to the financial markets due to the speed of the crisis. The
rapidity with which the crisis happened has prompted Sachs and others to
compare it to a classic bank run prompted by a sudden risk shock. Sachs points
to strict monetary and contractory fiscal policies implemented by the
governments at the advice of the IMF in the wake of the crisis, while Frederic
Mishkin points to the role of asymmetric information in the financial markets
that led to a "herd mentality" among investors that magnified a relatively small
risk in the real economy. The crisis has thus attracted interest from behavioural
economists interested in market psychology.
However, some believed that the Asian crisis was created not by market
psychology but by macroeconomic policies of the crisis-hit countries that
distorted information, which in turn created the volatility that attracted
speculators. According to this argument, what some have called "herd
mentality" was merely the result of speculators behaving rationally, noting the
fraudulent currency policies of the countries (fixed exchange rates defended
by the-governments),which speculators assumed could not be sustained.

16.4.3 Role of the IMP

The role of the IMF has been considered quite controversial during the crisis.
To begin with, many commentators in retrospect criticised the IMF for
encouraging the developing economies of Asia down the path of "fast track
capitalism", meaning liberalisation of the financial sector (i.e. elimination of
restrictions on capital flows); maintenance of high domestic interest rates in
order to suck in portfolio investment and bank capital; and pegging of the
national currency to the dollar to reassure foreign investors against currency
risk.
However, the greatest criticism of the IMF's role in the crisis was targeted
towards its response. As country after country fell into crisis, many local
businesses and governments that had taken loan's in US dollars, which
suddenly became much more expensive relative to the local currency, which
formed their earned income, found themselves unable to pay their creditors.
The dynamics in this scenario were similar to that of the Latin American debt
crisis. In response, the IMF offered to step-in in the case of each nation and
offer it a multi-billion dollar "rescue package" to enable these nations to avoid
default.
However, the IMF's support was conditional on a series of drastic economic
reforms influenced by neoliberal economic principles called a structural
adjustment package (SAP). The SAP'S called on crisis nations to cut
government spending to reduce deficits, allow insolvent banks and financial
institutions to fail, and aggressivelyraise interest rates. The reasoning was that
these steps would restore confidence in the nations' fiscal solvency, penalise
insolvent companies, and protect currency values.
But the effects of the SAP'S were rather mixed and their impact controversial.
Critics noted the contractionary nature of these policies, arguing that in a
recession, the traditional response is to increase government spending, support
major companies, and lower interest rates. The reasoning was that by
stimulatingthe economy and eliminating recession, governments could restore
onnfiA-om

x x ~ h ; l* t~m x r m n t ; n n

monnnmio n ~ i n

16.4.4 Lessons from the Crisis

lnternatlonal Capital
Mobility and the
Emerging Monernty
System

Some of the major lessons fiom the crisis are:

i)
ii)
iii)
iv)
v)
vi)

Sound Macroeconomic and Exchange Rate Management

Development of Financial Market Structure and Regulation
Strengthening of Financial Supervision and Oversight Mechanism
Development of Non-Bank Financial Sector
Developing Frameworks for Bank and Corporate Crisis Resolution
Crisis Prevention and Management

(a)

Tax to Check Volatile Capital Flows

One of the major lessons for developing countries in the context of the crisis is
to exercise caution in opening capital accounts and short-term capital inflows.
One of the remedial measures for checking volatile capital flows is suggested
to be in the form of a tax on international capital transactions, widely known as
the 'Tobin Tax' (Box 16.1).
r

Box 16.1 :Tobin Tax Proposal

Tobin Taxes are excise taxes on cross-border currency transactions. They can be
enacted by national legislatures, followed by multilateral cooperation for effective
enforcement. The revenue should-goto global priorities: basic environmental and
human needs. Such taxes will help tame currency market volatility and restore
national economic sovereignty. (The name Tobin Tax and the original concept
derives from James Tobin, a Ph.D. Nobel-laureate economist at Yale University.)

Source: http://www.ceedweb.org/iirp/
R

Interest in the potential for taxing international capital flow stems fiom
concern that exchange rates under floating regimes are too volatile, and that
exchange rate target zones are too vulnerable to real shocks or inconsistent
macroeconomic policies. A contributing factor in both cases is the rapid
development of capital mobility in the last decade, deriving fiom capital
markets liberalisation and technological innovation. The crisis-situations in
several parts of the world including the Asian region have given further
impetus to this idea.
(b)

Regional Financial Cooperation

The ASEAN countries believed that the well co-ordinated manipulation of

currencies by speculators was a deliberate attempt to destabilise the ASEAN
economies. At the 30th ASEAN Ministerial Meeting held in Malaysia they
issued a joint declaration on 25 July 1997 expressing serious concern and called
for further intensification of ASEAN's cooperation to safeguard and promote
ASEAN's interest in this regard.
As a response to the crisis, Asian countries began to consider establishing
regional financial facilities. This was a reflection of their views that the
provisions of international financial assistance through .existing multilateral
arrangements had been neither timely nor sufficient to deal with the crisis.
Finally, the finance ministers of ASEAN+3 (China, Japan and South Korea)
countries reached an agreement on the Chiang Mai Initiative (CMI), which
was the first significant regional financing arrangement to enable countries to

Theory of R-ioaal B i w

cope with disruptive capital flows and maintain exchange rate stability in
Thailand in May 2000.
(c)

Reforming International Financial Architecture

The crisis has also prompted for a comprehensive review of the present
architectureof the international monetary system. With a view to developing, a
framework to prevent, manage and resolve future crisis, within the context of a
global environment of liberalised capital flows it is necessary to institute an
international financial architecture responsive to developing countries' needs.
In this regard, some reforms of the IMF may be necessary to reduce contagion
effects of similar crises in the future. There is a need to develop a mechanism
to provide for an orderly resolution of any financial crisis in the future, as what
is lacking is an effective rule-based and adequately funded international l&der
of last resort. The IMF needs to seriously consider assuming this role, and
make changes in the terms and conditions of its financial support facilities, to
better assist countries affected by the crisis and effectively stabilise the economy
and financial markets.
(d)

Devising Adequate Social Safety Nets

One of the most important lessons of the Asian crisis is that adequate social
safety nets need to be set in place. In the era of global interdependence
including in the area of capital markets, risk of crisis would always remain
with economic openness. While it is imperative to calibrate capital market
integration and regulate short term volatile capital flows, it is equally
important to build institutional mechanisms to deal with occasions of crisis. To
this end, one of the very significant responses at the national level would be to
develop adequate social safety nets for the people. This would help minimising
the adverse impact of crisis on those who are already poor those whose social
conditions deteriorate due to crisis as experienced in all the countries of the
Asian region.

16.5 POST-MAASTRICHTDEVELOPMENTSAND
DEVELOPING COUNTRIES
The aim of the European Community, as per the recommendationsof the Werner
y
(EMU).
Report of 1972, was the establishment of a European ~ o n e h n Unibn
The original target date for EMU was set in that Report at 1980, but the
accession of Denmark, Eire and the United Kingdom in 1973 delayed
implementation of this goal. As you saw in the preceding Unit 15, in 1991 the
members of the EC signed the Maastricht Treaty. which declared their
intention to harmonise their domestic laws and policies as the European Union.
They also laid down a plan to move towards a monetary union with a single
currency and a single central bank. Most of the countries gave up their national
currencies and adopted a common currency, the Euro. This means that out of
the "impossible trinity", they gave up independent monetary policies.

'

Some guidance on the desirability of forming a monetary union is given by the

theory of optimum cumncy areas. This branch of economics i s concerned with
the criteria that determine the optimal coverage of a single currency. In Unit
8.8, you learned about .the various merits ind demerits of fixed and flexible
e y r h a n o e ratec

riirrenrviininn i c a n c?.utrme r a c e nf a f i x 4 eyrhancre r s t e in

International Capital
Moblllty and the
Emerging Moneraty
System

which the members adopt a common currency, and the costs and benefits are
similar. On the one hand, abolition of national currencies means that there is
no exchange rate risk between members, no transactions costs in converting
fiom one currency to another, and greater price transparency because all prices
in the union are expressed in a common currency. This facilitates trade and
capital investments between the countries. There is also greater monetary
discipline on the central bank. On the other hand, countries will have to give
up their independent monetary and exchange rate policies, which they could
use to offset domestic macroeconomic cycles.
If the countries already trade extensively amongst themselves, with large flows
of capital between them, then all the benefits listed above will be greater. Also,
if they undergo correlated macroeconomic cycles, then there is less conflict in
policy. Otherwise, one member country could be suffering from inflation
(requiring deflationary monetary policy and currency appreciation) while
another suffers from recession (calling for expansionary monetary policy and
depreciation). If labour is allowed to move freely between countries, then
uncorrelated cycles are less of a problem, because workers cap move from the
country with recession to those with expansion. It is also easier if taxes can be
imposed in the expanding region to support the workers in the stagnating
region. The EU comes closest to these conditions for a successful monetary
union. However, the Maastricht treaty had to impose on its members certain
macroeconomic performance targets to minimise the problems discussed above.
Not much work is available in terms of the intricate implications of European
monetary integration and adoption of euro for developing countries. They need
to be understood given the trade and investment relations that different
countries or regions in the developing world have. It would also depend upon
the use of euro as a currency of exchange between the EU and partner
developing countries. It is in this sense that countries of Latin America and
Africa would experience different impact than Asian countries. However, for
the Central and Eastern European Countries v i s - h i s their membership of the
EU has been analysed and studies have highlighted the dilemma that exists in
terms of choosing their exchange rate policies to achieve a combination of low
inflation and exchange rate stability while at the same time contemplating a
transition towards a peg to euro.
Especially, countries having more trade-intensity with EU, having eurodenominated debt and those whose currencies are pegged to euro would
experience different effects through different channels. For instance, changing
values between the euro on one hand and dollar or yen on the other could affect
such countries' external competitiveness. An increase in the value of the Euro
would benefit those countries that peg their currencies to the Euro, as it would
decrease the domestic currency cost of servicing such debt. Conversely, any
depreciation of the Euro would increase the cost of such debt service.
Price transparency in a single currency is likely to narrow the differences
between the prices paid for the same product in different European countries.
Therefore, the likely improvements in price transparency coupled with the
reduction in transaction costs due to elimination of risk would lower the
trading costs to the business sector in developing world.

Theory of Regional Blocs

Check Your Progress 3

1) What was role of IMF during Asian Crisis?

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2) What are the major reasons of Asian Crisis?

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3) Briefly discuss the theory of optimum currency weas.

16.6 LET US SUM UP

The Unit discusses different aspects of international capital mobility and the
emerging International Monetary System. It starts with Globalisation and
Macroeconomic Management. It gives a brief exposition of the standard ISLM model for an open economy with the possibility of capital flows. The Unit
discusses Evolution of International Monetary System and its Present Status. It
also explains to the learners Short-Term Capital Movements and East-Asian
Crisis - Lessons for Developing Countries.While discussingShort-Tenn Capital
Movements and East-Asian Crisis, the Unit explains Impact of Crisis, Causes
of Crisis, Role of the IMF and Lessons from the Crisis. The Unit ends with
Post-Maastricht Developments and Developing Countries.

16.7 KEY WORDS

Asian Crisis: A major financial crisis, which began in Thailand in July 1997
and quickly spread to other East Asian countries of the region.
Fiscal Policy: Any macroeconomic policy, which involves government
purchases, transfers, or taxes, usually implicitly focused on domestic goods,
residents, or firms. A fiscal stimulus is an increase in purchases or transfers or
a cut in taxes. Fiscal policy can be expansionary/contractionaryif it tends to
cause aggregate output (GDP) andlor the price level to increaselfall.

Impossible Trinity: The impossibility of combining all three of the following:

monetary independence, exchange rate stability, and full financial market
integration.
Maastricht Treaty: It is the 1991 treaty among members of the EU to work
toward a monetary union, or common currency. This ultimately resulted in
adoption of the euro in 1999.
Monetary Policy: The use of the money supply andor the interest rate to
influence the level of economic activity and other policy objectives including
the balance of payments or the exchange rate. Monetary policy can be
expansionary/ contractionary if it tends to cause aggregate output (GDP) a n d
or the price level to increase/fall.

16.8

SOME USEFUL REFERENCES

Krugman, Paul. 1994. The Myth of East Asia b miracle, Foreign Affairs, vol.
73 (November/December 1994), pp. 62-78.
I

Krugman, Paul. 1998. What Happened to Asia? httD://web.mit.edu/krunman.

Mundell, Robert A. 1961. A Theory of Optimum Currency Areas, American
Economic Review 5 1, (September), pp. 657-665.
Paul A. Samuelson and William D. Nordhaus. 1998. Economics: An
Introduction, 17thed., McGraw-Hill
Sachs, Jeffrey, Aaron Tomell and Andres Velasco. 1996. Financial Crises in
Emerging Markets: The Lessons from 1995, Brookings Papers on Economic
Activity, vol. 1: 147-215.
Sen, S. 2003. Global Finance at Risk, New York: Palgrave Macmillan.
Sodersten, B. and Reed, G 1994. International Economics, 3rd ed., London:
Macmillan.

16.9 ANSWERSIHINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 16.2
2) Read Section 16.2

International Capital
Mobility and the
Emerging Moneraty
System

Theory of Regional Blocs

Check Your Progress 2

1) Read Section 16.3
2) Read Section 16.3

Check Your Progress 3

1) Read Sub-section 16.4.3
2) Read Sub-section 16.4.4
3) Read Section 16.5