JS European Economy Week 3

Topic: Costs and Benefits of a Monetary Union

Main Reading De Grauwe chs 1-4

· Theory of Optimum Currency Areas (OCA)

· Benefits of MU

· Decision to go ahead with single currency

THEORY OF OPTIMUM CURRENCY AREAS (OCAs)

--------------------------------------------------------------

1. START WITH ASYMMETRIC SHOCKS

2. FOUR ADJUSTMENT MECHANISMS

· WAGE/PRICE FLEXIBILITY

· LABOUR MOBILITY

· REDISTRIBUTION

· CHANGE EXCHANGE RATE (DEVALUE/REVALUE)

3. CONCLUSION: MONETARY UNION OPTIMAL IF:

· WAGES FLEXIBLE (NOMINAL and/or REAL?)

· LABOUR IS MOBILE

· STRONG CENTRAL BUDGETARY MECHANISMS

THE LESS LIKELY ARE THESE CONDITIONS TO BE SATISFIED, THE MORE COSTLY IS MU


DELVING DEEPER INTO OCA THEORY

-----------------------------------------------

1. TYPOLOGY OF ASYMMETRIC SHOCKS

DEMAND, SUPPLY, PERMANENT, TEMPORARY

2. ROLE OF DOMESTIC MONETARY AND FISCAL POLICY IN GENERATING SHOCKS

3. HOW IMPORTANT ARE ASYMMETRIC SHOCKS IN AN EMPIRICAL SENSE?

3. EFFECTIVENESS OF EXCHANGE RATE CHANGES AS RESPONSE TO SHOCKS

· “IMPORTED INFLATION” ARGUMENT

· MONEY ILLUSION ARGUMENT

· ABUSE OF DEVALUATION OPTION BY POLITICAL IMPERATIVES

§ Leading to loss of “reputation”, credibility problems etc

4. IMPORTANCE OF DEGREE OF OPENNESS: NOT JUST

TRADE BUT CAPITAL MOBILITY AND CONSUMPTION SMOOTHING

THE DYNAMICS OF MU – MAKING ASYMMETRIC SHOCKS LESS LIKELY?

Pay Co-Ordination, Policy Surveillance


ARE OCAs ENDOGENOUS?

· A sizeable body of evidence exists on the importance of policy-driven cyclical asymmetry.

· If independent monetary policies are a source of cyclical divergence rather than a smoothing device in the face of asymmetric real shocks, then OCAs may well be endogenous (Buiter SJPE 2000).

· Comparison of business-cycle correlations across US regions and across EU countries indicates that a shared monetary policy is itself a source of cyclical convergence.

· Available empirical evidence favours hypothesis that MU can increase the symmetry of macro fluctuations, i.e. that OCAs are endogenous.


Update to 2002

· The current economic downturn is affecting all industrial nations in the same direction, this is singular feature of the present world economy. Business fluctuations are becoming more synchronous (i.e. shocks are more symmetric than asymmetric)

· If shocks are symmetric in the euro area, instead of asymmetric, then we come to a completely different conclusion about the usefulness of independent exchange rate and monetary policy. Where symmetric shocks are the rule, it is better to have a single monetary policy than twelve separate monetary/exchange rate policies.

· The reason is that separate policies could lead to problems of competitive depreciations in face of a downward shock. This would in turn put pressure on the single market.

· The fear that competitive devaluations would undermine the single market – and undo all the benefits from closer market integration – was a powerful motivating force for setting up the common currency.


Leaving aside problems of shocks, what are the long term advantages of a single currency?

• TRANSACTION COSTS

• ER UNCERTAINTY AND INTEREST RATES

• PRICE TRANSPARENCY

• EXTERNAL GAINS - reserve currency and seigniorage

· EFFECTS ON ECONOMIC GROWTH

· OTHER

saving the single market

effects on foreign investment

• CREDIBILITY

facilitates anti-inflation and appropriate wages policies (endogenous policy argument)


COSTS OF EMU

1. LOSS OF AUTONOMY IN EXCHANGE RATE AND

MONETARY POLICY

a) incidence of "asymmetric shocks"

b) extent to which these shocks affect economic performance

2. TRANSITION COSTS - implementation costs, training costs, cost of lost business to financial institutions

3. RESTRAINTS ON FISCAL AUTONOMY


POLICIES TO MAXIMISE BENEFITS AND MINIMISE COSTS OF EMU

· FOR ‘INS’

MONETARY POLICY STRATEGY

Minimising the risk that ECB might fail (UK objection)

Monetary institutions

Monetary objectives

Money and the exchange rate

ECONOMIC POLICY STRATEGY

Fiscal rules

Stability and Growth Pact

Broad Economic Guidelines

credible budgetary consolidation

appropriate wage and pay developments

structural reforms

better functioning of markets

promoting innovation, competition and developing human capital

safeguarding the profitability of investment

Subsidiarity

Regional convergence (Structural Funds, regional counter-balancing)

CONCLUSIONS

We have reviewed the main benefits and costs of a single currency. We see the impressive sophistication of the arguments for and against. As so often in economics, the economics empirics yield conflicting and inconclusive results.

Faced with this theoretical uncertainty as to outcome of a single currency, EU policy makers decided to push ahead, putting faith in the endogenous policy arguments for those countries particularly prone to asymmetrical shocks, setting severe institutional constraints designed to minimise the dangers of crises, and relying on the process of incrementalism to provide the political support necessary to make this dramatic and unprecedented initiative work.

Jseuro\oca 8