Transcript OPTIMAL CURRCENY

OPTIMAL
CURRENCY
AREA I
Week 2
Chapter 1 and 2.
What we have learnt last
week
• Countries use macroeconomic policy (monetary,
fiscal, exchange rate) for aggregate demand
management in the short-run (to fight downturns
or to prevent inflationary pressures)
• to keep aggregate demand in line with potential
output growth
• which is ultimately determined by long-run
supply-side factors (total factor productivity,
labour force growth)
• MACROECONOMIC POLICY REACTS TO SHOCKS
Plan of Week 2 and 3
• 1) The costs of a monetary union
(Optimal Currency Area theory)
• 2) OCA critiques
• 3) The benefits of a monetary union
THE COSTS OF A
MONETARY UNION
• Joining a monetary union implies the lost of two
out of three national macroeconomic policies:
• Monetary policy: a common central bank prints
the new currency and is in charge of determining
the short-term interest rate
• Exchange rate policy: national currencies
disappear, so there’s no chance of
altering/determining its external value to restore
competiveness (depreciation) or to decrease
imports price (appreciation)
• When a country joins a monetary union, it looses
the ability of determining two of the three prices
of money:
• Interest rate
• Exchange rate
• (it still can affect inflation, by pushing aggregate
demand via fiscal policy)
A country looses two of the three “weapons”
against recessions and shocks, and its overall
“fighting” ability is severly undermined.
So in order for monetary union to be desirable,
countries must have some other mechanism at
work to fight recessions and restore
macroeconomic equilibrium.
• Optimal Currency Area
(OCA)
• (Robert Mundell, 1961)
• It defines the conditions under which it is optimal
for a group of countries to form a monetary union
• Optimal…?
• There are other forces capable of fighting
asymmetric shocks (events that affect countries
in opposite ways)
• A shift in demand from German to French
products
• A oli price shock (it helps exportes, it damages
importers)
What are those
mechanisms/forces?
• Competition forces (free market forces) on prices
(a) and quantities (b) of labour:
• a) wages
• b) migration of workers
Back to the most important diagram in
macroeconomics
Aggregate demand, aggregate supply
Negative shock in France, positive in
Germany (AD curve shifts)
• a) If wages are flexible, they will decline in
France (AS curve shifts rightward) and rise in
Germany (AS curve shifts leftward).
Macroeconomic equilibrium is restored in both
countries.
• b) If there is mobility of labour, unemployed
workers will migrate from France to Germany
(eliminating the need for wage decline in F and
wage increase in G)
• SUPPLY SIDE FORCES (acting through labour
market), LED BY FREE MARKET AND
COMPETITION, RESTORE MACROECONOMIC
EQUILIBRIUM IN BOTH COUNTRIES.
But what would be the easier
solution…?
• Use macroeconomic policy.
• Expansionary in France (decrease interest rate,
devaluate exchange rate)
• Contractionary in Germany (increase interest
rate, revaluate exchange rate)
• Monetary policy and/or exchange rate policy just
bring back AD curve where it used to be before
the (asymmetric shock).
• But if countries are in a monetary union, they
just cannot do that.
So……
• In presence of wage flexibility and mobility of
labour countries have the necessary marketbased tools to fight asymmetric shocks, and thus
they can afford to give up (most of the) national
macroeconomic policies. They form a Optimal
Currency Area
• If those adjustment mechanisms are prevented,
the cost of joining a monetary union (loosing two
of the three macro weapons) are too high and
dangerous.
Why should those adjustment mechanism
be prevented?
•
a) Are wages fully flexible? Do they really (and
quickly) increase during booms and decrease
during downturns? (staggered contracts, trade
unions……nominal and real labour market
rigidities).
• b) Are workers really perfectly mobile?
(languages, cultural barriers, family ties)
What’s the case in Europe?
a) Rigidity in the labour (and goods) market
b) 23 different languages and immigration
concerns (the “Polish plummer”)
• When euro was for the first time put forward, a
long list of prominent economists predicted
failure of the monetary union. Starting from
Robert Mundell himself.
• Ten years later (1999-2009) they all had to admit
that they were wrong. For basically two reasons:
a) OCA theory itself can be subject to
criticisms.
b) There are also benefits from sharing a
common currency.
We’ll go through a) next week.
Today:
- we’ll analyze in greater details the argument for
not-having a single currency
- we’ll explore a).
“Countries are different and so they
cannot wear the same jacket”
• Or, better……
• Countries differ for many economic and
institutional features.
• Thus they cannot share the same interest rate
and the same exchange rate, because it would be
as if you tried to have different size people wear
the same clothes.
• There is too much heterogeneity in EU national
economies.
• Let’s see the main sources of heterogeneity.
1) Different preferences on
inflation/unemployment combination
• Look at AD curve movement along the AS curve.
• More unemployment (=lower GDP growth), less
inflation
• Less unemployment (=higher GDP growth), more
inflation.
• So there is a negative relationship between
inflation () and unemployment (U):
• The Phillips Curve (Phillips, 1958)
inflation
unemployment
• Open-economy equilibrium
condition: E    
• If Italy wants to have an
inflation rate higher than
Germany’s (or does not
manage to reduce it), then
it has to depreciate its
exchange rate accordingly,
to compensate for the
reduced competitiviness.

G
I

E  G   I
• In fact:
• If italian inflation is higher: Italy looses
competitiveness (goods and services are more
expensive, and thus they loose market shares)
• If exchange rate is lower: Italy gains
competitiveness (it takes fewer dollars to buy 1
euro, so the dollar price of a european product is
artificially lower)
• “Artificially” because the lower price does not depend on
lower production costs, more innovation, better technology,
but merely on the lower value of the unit of account.
• If countries do not form a monetary union, then
they are free to choose whatever combination
they like on the Phillips curve:
• High inflation, lower unemployment (Italy)
• Low inflation, higher unemployment (Germany)
Inflation differentials will be offset by exchange rate
(consistent with them being different sides of the
same coin: prices of money)
In fact, italian lira kept depreciating towards
German mark throughout the decades.
• If countries form a monetary union, then inflation
differentials cannot be compensated by exchange
rate.
• So if Italy does not want to suffer sever market
share losses, it has to harmonize its inflation rate
with Germany.
• So countries are no longer free to choose the
best point on their Phillips curve. That is a cost.
• Anticipation of point 1 critiques: are you sure
that countries are permanently free to choose
their best combination? To reduce unemployment
by suffering a little bit of inflation?
2) Differences in labour market institutions
• Labour markets differ consistently across
countries.
• More or less flexibility
• More or less centralization
• Trade unions role and bargaining process.
• Idea: supply shocks transmission (i.e. oil price
increase) varies across countries according to the
functioning of labour market institutions
• WAGE CLAIM MODERATION
• High degree of centralization in wage bargaining:
unions internalize that excessive nominal wage
increase will lead to more inflation, and therefore
will not preserve real wage
• Low degree of centralization (wage bargaining at
firm level): due to little bargaining power, any
excessive wage claim will lead to strong
employment reduction
• WAGE CLAIM NON-MODERATION
• Any intermediate level of centralization (many
small unions) will create a situation where each
union does not internalize the aggregate
problem: they think that their own wage increase
will have a negligible effect on aggregate wage
(and therefore price) level (and they are right!)
• But any other union will act the same way
• Standing-up game at the football match
• As a result, nominal wage level will increse, AS
curve will shift further leftwards, price level will
futher increase.
• Transmission of supply shocks may be very
different according to the functioning of labour
market.
• Countries with very different labour market
institutions might find it costly to form a
monetary union: with asymmetric supply shocks,
wages and prices are affected differently (and
nation-specific policy responses are no longer
available) and so OCA-automatic-mechanisms are
not uniform.
• EU nations’labour market are indeed very
different:
• UK, Denmark: flexibility
• Italy, Greece, France: rigidity
3) Differences in legal system and interest
rate transmission
• An 1% increase in interest rate can have different
effects on EU national economies, due to:
• a) differences in banking system (degree of
competition, regulation, legal framworks)
• b) differences in companies’financing (through
capital market or banks)
• Financial market integration is indeed a goal of
EU integration process (Week 10)
4) Differences in growth rates
• I am sorry……
The case for non-euro
• 1) EU nations are not a OCA, so they are gonna
need nation-specific macroeconomic policies.
• 2) There are other reasons why monetary union
is not a good idea:
a) They would not be able to choose their own
preferred best inflation/unemployment
combination (since they cannot use exchange
rate to compensate inflation differentials)
b) Difference in labour market institutions
change supply shock transmissions (and thus
weakens OCA-forces)
• c) Interest rate transmission mechanism differ
across countries (due to legal system and
companies financing), so a common interest rate
won’t fit everyone.
• d) Fear for increased divergence.
OCA critiques
•
•
•
•
1.
2.
3.
4.
Are asymmetric shocks likely?
Labour market
Different legal system and financial markets
Do difference in growth really matters?
1. How likely are asymmetric shocks?
• Two opposite views:
• 1) Integration increases symmetry
• 2) Integration decreases symmetry
• 1) As trade and economic integration advance,
industrial structure (from an industrial point of
view) and business cycle (from a macroeconomic
point of view) are more synchronized
• 2) The more integrated the market, the more
room for specialization and core-periphery
patterns (concentration of industrial activities).
• Good review and discussion (pag.26 e 27).
• Evidence seems to point out that integration
helps business cylce synchronization (how often
do you observe recession in France and boom in
Spain?). Business cylce is now even harmonized
across the Atlantic.
• Are we sure that other monetary areas (Russian
Federation, US) are more optimal as far as
asymmetric shocks are concerned?
• The other OCA feature (mobility of labour)
actually seems more of a problem; not so much
because it is prevented (it is the second defining
feature of economic union, second floor of the
building), but because of cultural and language
barriers.
2) Labour market differences
• Common monetary policy will tend to harmonize
de facto wage bargaining process, since
potentially different wage claims face now the
same monetary policy reaction (“I will / won’t
accomodate more inflation deriving from your
wage demands”).
• Virtually every ECB Monthly Bulletin (one is in
your reading material) contains call for EU-wide
wage moderation.
3) Different legal and financial
system
• Economic integration means also financial market
integration, a largely incomplete process (Week 10).
• Most of the systematic differences in monetary policy
transmission (different effects of interest rate movements)
were due to underlying difference in inflation rates.
• In high inflation countries, short-term government bonds
prevails (short-term maturity) because no one wants to see
the value of their money eroded by inflation. As a result, an
increase in interest rate has more severe immediate
consequences for high-inflation country’s governments and
corporations.
• But as inflation differentials disappears (as it is the case in
a monetary union), also do these differences.
NEXT WEEK
• The most important counterargoment to OCA theory:
• How effective are national
monetary policies? (ch.2, par.2)