Transcript Slide 1

320.326: Monetary Economics
and the European Union
Lecture 8
Instructor: Prof Robert Hill
The Costs and Benefits of Monetary Union II
De Grauwe – Chapters 3, 4, 5
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1. Time Inconsistency and the Barro-Gordon Model
Why have many countries made their central banks independent?
At least part of the answer is to overcome the time inconsistency
problem. This problem is illustrated by the Barro-Gordon model.
We assume that the central bank has the following loss function.
L = (π – π*)2 + b(u – u*)2
where π* and u* denote the target inflation and unemployment rates.
We assume that π*=0 and u* = λuN, where uN denotes the natural
rate of unemployment.
The short-run Phillips curve is assumed to take the following form:
u = uN – a(π – πe) + ε.
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where πe is the expected rate of inflation and ε is a stochastic
disturbance.
The short-run Phillips curve and central bank indifference curves
are graphed in Figures 2.9 and 2.10.
The impact of changes in the parameter b in the loss function are
shown in Figure 2.11.
The equilibrium outcome is shown in Figure 2.12.
Starting from a situation where πe = 0 (i.e. point A), the central
bank has an incentive to exploit the short-run Phillips curve, and
move the economy to point B. However, once the market adjusts
its expected rate of inflation to this new level, the central bank
now has an incentive to again exploit the short-run Phillips curve
and move to C, etc.
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Point E is the rational expectations equilibrium.
At point E, the central bank finds itself at its preferred point on the
short-run Phillips curve, and hence no longer has any reason to try
and further exploit the short-run trade off between inflation and
unemployment.
This model provides a motivation for why central banks should be
made independent, so as to enable the economy to end up at point A
rather than E. Otherwise, politicians always have an incentive to
exploit the short-run Phillips curve.
That is, the policy of zero inflation is not time consistent for the
government (when λ < 1 and b > 0).
Note: even an independent central bank is not immune from time
inconsistency.
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Algebraically, the rational expectations equilibrium at point E
is obtained in the Barro-Gordon model by first eliminating u
from the loss function using the short-run Phillips curve.
L = π2 + b[a(πe – π) + (1 – λ)uN + ε]2
The optimal value of π for the central bank is obtained by
differentiating L with respect to π, and setting the derivative
equal to zero.
π = [a2b/(1+a2b)] πe + [ab(1– λ)/(1+a2b)] uN + [ab/(1+a2b)] ε
(*)
Under rational expectations, the market takes account of the
central bank’s loss function when forming its expectations.
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It follows that
πe = [a2b/(1+a2b)] πe + [ab(1– λ)/(1+a2b)] uN
Solving for πe, we obtain that
πe = ab(1– λ)uN
(**).
That is, the equilibrium inflation rate corresponding to point E
in Figure 2.12 is an increasing function of a and b, and a
decreasing function of λ.
When λ =1 or b=0, πe = 0. There is no time inconsistency
problem in these cases.
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Substituting for uN from (**) into (*), the actual rate of
inflation can be rewritten as follows:
π = πe + [ab/(1+a2b)] ε
Now, substituting back into the Phillips curve we obtain that
u = uN + [1/(1+a2b)] ε.
Unemployment on average equals its natural rate uN. The
impact of a shock ε is partially mitigated by the central bank’s
response, which depends on the parameter b from its loss
function. The higher the value of b, the smaller are the
fluctuations of unemployment around uN.
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A Barro-Gordon perspective on the situation faced by Germany
and Italy prior to monetary union is shown in Figure 2.15.
As a result of the tougher stance of the German central bank (i.e.,
its lower level of the parameter b) the equilibrium level of inflation
is lower than in Italy.
Monetary union, assuming the European Central Bank (ECB)
has the same preferences and credibility as the German central
bank had prior to monetary union, allows Italy to achieve point
F in Figure 2.15.
Note: this model is not consistent with Bernanke’s concept of
constrained discretion. Greater inflation fighting credibility
implies bigger fluctuations in output.
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Suppose shocks periodically hit the economy and that these shocks
shift the short-run Phillips curve.
The central bank responds to an upward shift of the short-run
Phillips curve with an expansionary monetary policy.
Figures 2.16 and 2.17 contrast the cases of a soft and tough central
bank. The soft central bank achieves greater stabilization of output
and unemployment. However, this is achieved at the price of a
higher equilibrium rate of inflation.
Implication: the stabilizing effect of monetary policy comes at the
price of higher inflation. This needs to be taken into account when
assessing the advantages and disadvantages of monetary union.
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2. Countries in Trouble in the Eurozone That Followed
Irresponsible Fiscal Policies Leading Up to the Crisis
Greece’s debt-to-GDP ratio: 1990
2000
2007
2013
79.6 percent
114.9 percent
103.8 percent
171.8 percent
Italy’s debt-to-GDP ratio:
97.3 percent
121.6 percent
116.9 percent
132.9 percent
1990
2000
2007
2013
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2. Countries in Trouble in the Eurozone that Did Not Follow
Irresponsible Fiscal Policies Leading Up to the Crisis
Ireland’s debt-to-GDP ratio: 1990
2000
2007
2013
93.3 percent
37.8 percent
29.2 percent
124.8 percent
Spain’s debt-to-GDP ratio:
47.7 percent
66.5 percent
42.8 percent
93.4 percent
1990
2000
2007
2013
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Debt to GDP Ratios for European Countries
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Spain
Sweden
UK
1970
18.5
61.9
n.a.
n.a.
40.0
17.5
18.8
n.a.
55.1
65.5
n.a.
29.1
80.9
1980
35.8
74.5
43.7
13.6
29.7
30.2
22.8
69.5
86.6
59.1
19.9
47.2
55.9
1990
57.2
125.8
66.4
16.3
38.6
40.4
79.6
93.3
97.3
87.8
47.7
46.7
32.9
2000
69.4
113.4
57.1
52.3
65.2
60.4
114.9
37.8
121.6
63.9
66.5
65.7
45.6
2010
72.3
96.7
43.6
48.4
81.6
83.4
142.8
96.2
119.1
62.7
60.1
39.8
80.0
2013
77.1
103.7
46.3
54.8
92.7
78.4
171.8
124.8
132.9
73.6
93.4
40.7
89.1
Source: OECD Economic Outlook and Eurostat
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3. Why Did the Debt-to-GDP Ratios in Ireland and Spain
Rise So Much with the Onset of the Crisis?
Both countries had real estate booms that were financed by loans
from banks and other financial institutions.
Banks make money by lending long-term and borrowing
short-term. This is because the interest banks charge on
mortgages is higher than the interest they pay on their short-term
borrowing.
In the years before the crisis there was a big increase in the
amount of short-term debt held by banks and other financial
institutions in Ireland and Spain.
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With the start of the financial crisis liquidity in the short-term
credit market dried up (due to a big increase in perceived
counterparty default risk). Banks were no longer able to rollover
their debts.
The Irish and Spanish governments were forced to lend to the
banks to prevent them defaulting. The banks debts were more or
less taken over by the government.
At the same time the housing markets fell in Ireland and Spain,
and mortgage holders started to default on their loans. The value
of the banks’ assets fell.
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Note: if the bank loans are still sound then the banks are facing a
liquidity problem. If enough mortgage holders default and the value
of the houses falls below the value of the mortgages, then the banks
may become insolvent.
This is a key difference between countries that experienced
housing booms and busts and those that did not.
In most other countries the financial crisis created a temporary
liquidity crisis for banks. In countries that had housing busts, the
banks may have also become insolvent.
The government was forced to bail them out. If not, one bank
collapsing can then trigger collapses at other banks endangering the
whole financial system.
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A similar thing happened in Iceland, except that it was aggressive
international expansion of the banking sector rather than a
housing bust that caused the problem.
The combination of the financial crisis and housing bust triggered
bad recessions in Ireland and Spain.
(i) Banks stopped lending, causing a credit crunch. Hence
investment fell.
(ii) The fall in house prices reduced household wealth and hence
consumption fell.
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(iii) Government debt rose dramatically as a result of bailing out
banks, and due to the fall in tax revenue from rising
unemployment and falling house purchases.
Lenders became concerned about the Government’s ability to
service its debt, forcing a tightening of fiscal policy. Tightening
fiscal policy made the recession worse.
The combination of (i), (ii) and (iii) caused a big fall in aggregate
demand which sent both economies into recession.
This in turn acted to further reduce tax revenue and increase
government expenditure (as unemployment rose) putting still
more pressure on the government budget.
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As GDP fell this also worsened the debt-to-GDP ratio.
During the boom, Ireland and Spain were also becoming less
competitive since wages were rising too fast. This helped make
the recession even worse when the boom ended.
4. How Did Greece and Italy Accumulate So Much Debt
Before the Crisis?
Entry into the Eurozone allowed member countries to issue
Euro denominated bonds.
The market decided that Greek/Italian bonds denominated in
Euros were less risky than Greek/Italian bonds denominated in
Drachma/Lira.
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Hence Greece and Italy were able to borrow more and at a
lower interest rate than they would have been otherwise able to.
The markets ignored two risks associated with buying Greek
bonds.
(i) The Government could default on its bonds.
(ii) It could be forced out of the Eurozone and then convert
these bonds into Drachma at a very devalued rate.
Greece and Italy also become less competitive after monetary
union since (productivity adjusted) wages rose faster than
in Germany.
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5. The Benefits of a Common Currency
(i) Elimination of transaction costs
These are the costs incurred buying and selling foreign
exchange.
The EU Commission has estimated that the elimination of
transaction costs as a result of monetary union save firms
and households about 13 to 20 billion Euros a year
This is between 0.25 and 0.5 percent of EU GDP.
Banks lose out – about 5 percent of bank revenue prior to
monetary union came from fees charged for foreign
exchange transactions.
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Even with monetary union, bank transfers between Euro-zone
countries are more expensive than within country transfers.
The European Commission is pressuring the banks to eliminate
these differences.
(ii) Greater price transparency
Differences in prices across Eurozone countries are more
transparent after monetary union. This might stimulate greater
competition and hence lower prices.
In 2000, the differences across countries were much larger
than within countries –See Table 3.1.
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According to Wolszczak-Derlacz (2006), this gap has not
narrowed since 2000 – see Figure 3.1.
This may be because retail markets across Euro-zone countries
are still quite segmented. For example, a few supermarket
chains dominate in each country. It can be difficult for a new
chain to establish itself.
Also transport costs make it hard for consumers to exploit
arbitrage opportunities.
(iii) Reduced uncertainty
Uncertainty about future real exchange rates may discourage
investment and attempts by firms to establish market share in
other countries.
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A significant appreciation of the domestic currency can impose
large costs on exporters.
The large appreciation of the US dollar from 1980-5
hurt a number of exporting US firms, and led to some closures.
Example: Suppose exchange rate changed from 1 dollar = 1 Euro
to 1 dollar = 1.5 Euros.
If a US firm wants to receive $100 for each unit of a good sold
in Europe, after the appreciation of the dollar it must raise its
Euro price from 100 to 150. This will cause it to lose market
share, which will reduce profits.
If it keeps the price at 100 Euros, then the firm will only receive
$67 for each unit sold. This will also reduce profits.
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Monetary union however does not necessarily reduce systemic risk.
A reduction in exchange rate risk could be countered by increased
volatility in domestic output (since monetary policy can no longer
be used to respond to country specific shocks).
These shocks could hit either the goods or money market.
The former (i.e., shocks to the goods market) are considered
in Figure B6.1. Under monetary union, a rightward shift of
the IS curve causes an increased demand for goods. More money
flows into the country from the rest of the union to meet this
demand. This shifts the LM curve to the right.
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With a freely floating exchange rate, the rightward shift of the IS
curve exerts upward pressure on the interest rate. The rise in output
is dampened by the fall in investment and appreciation of the
currency triggered by the rise in interest rates.
Conclusion: fluctuations in output are bigger under monetary
union.
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The latter (i.e., shocks to the money market) are considered in
Figure B6.2. Under monetary union, a rightward shift of the
LM curve causes an outflow of money, since the amount of
money circulating exceeds the demand for goods. This shifts
the LM curve back to the left.
With a freely floating exchange rate, the rightward shift of the LM
curve causes the interest rate to fall, which stimulates investment
and causes the currency to depreciate increasing net exports.
Conclusion: fluctuations in output are smaller under monetary
union.
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(iv) Increased trade between the member countries
Monetary union has stimulated greater integration of financial
markets and institutions across the member countries.
This should help increase trade between the member countries.
Current estimates are that monetary union has boosted trade
between member countries by between 5 and 20 percent.
Increased trade allows each country to exploit its comparative
advantages. This should benefit all countries in the union.
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(v) Monetary union helps create an environment conducive to
monetary union
Frankel and Rose have argued that monetary union stimulates
trade between the member countries which tends to harmonize
their business cycles and make them less likely to be hit by
asymmetric shocks.
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6. Comparing Costs and Benefits
The benefits of monetary union tend to rise with the level of
trade with other countries in the union.
Assuming that increased trade causes increased symmetry
(see Figure 2.1), then the costs of monetary union decrease
with the level of within union trade.
In this case, whether monetary union is desirable for a
particular country may depend on the level of within union
trade that results (if more trade implies more symmetry).
See Figure 4.1.
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The benefits of monetary union (through lower transaction
costs and lower exchange rate uncertainty) increase with the
amount of trade between countries in the union. Hence the
benefit curve is upward sloping.
The costs of monetary union decrease with more trade
(assuming trade makes the countries more symmetric).
Hence the cost curve is downward sloping.
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Estimates of within union trade for the EU countries are
provided in Table 4.1.
The results suggest that monetary union is desirable for Belgium,
the Czech Republic, and the Netherlands, but less so for Italy,
Spain, the UK and Greece.
Note: there are other advantages of monetary union, such as
tapping into the ECB’s inflation fighting credibility. This alone
at the time seemed like a sufficient justification for Italy and
Greece to join the monetary union.
The gains though are illusory if wages continue rising. In this
case the country becomes gradually less competitive leading to
recession and unemployment.
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Figure 4.4 provides an alternative way of comparing the
desirability of monetary union.
The desirability of monetary union is an increasing function of:
(a) the symmetry of the member countries (since this reduces the
likelihood of the countries being hit by asymmetric shocks).
(b) the flexibility of the labour markets of the member countries
(e.g. wage flexibility and mobility of labour). Greater
flexibility reduces the impact of asymmetric shocks.
It follows that we can construct a downward sloping frontier in
flexibility-symmetry space, such that groups of countries above
the frontier are optimal currency areas, while those below the
frontier are not.
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Figure 4.4 implies that a lack of symmetry can be compensated
for by greater labour market flexibility.
The current consensus is that a subset of the EU (e.g., Germany,
France, Belgium, the Netherlands, Luxembourg and Austria)
are an optimal currency area (OCA), the EU-25 countries are not
an OCA. Further eastward expansion of the EU will move it
further away from an OCA.
Most economists believe that the US is an OCA, although this is
more due to labour market flexibility than symmetry. For example,
car production is centred on Michigan. This is due to economies
of scale (as argued by Krugman).
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The OPEC oil shocks of the 1970s caused recessions in the US.
In both cases, Michigan was hit worse than the rest of the US
(see Figure 4.5).
A major part of Michigan’s recovery (relative to the rest of the
US) was driven by emigration from Michigan to the rest of the
US (see Figure 4.7).
By contrast, Belgium’s recovery from recession over the same
period (relative to the rest of the EU) was driven by a
depreciation of the Belgian franc (see Figures 4.6 and 4.8).
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We can also measure the desirability of monetary union as a
function of trade integration and symmetry.
The desirability of monetary union is an increasing function of:
(a) the symmetry of the member countries (since this reduces
the likelihood of the countries being hit by asymmetric
shocks).
(b) the extent of trade integration. This is because greater
integration increases the gains from lower transaction costs
and avoiding exchange rate uncertainty.
The OCA frontier is again downward sloping. Groups of
countries above the frontier are OCAs (see Figure 4.9).
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If increased integration leads to increased symmetry, then the
Eurozone countries will move to the right over time in Figure
4.9. hence even if they are not an OCA to begin with, they
may become so over time.
If instead the Krugman view is correct, then trade integration
will cause the Eurozone to diverge from an OCA over time
(see Figure 4.10).
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7. Other Monetary Unions
(i) Enlargement of the EU
Most of the new entrants to the EU are more integrated with it
than are Denmark, Sweden and the UK (the three older members
not in the Eurozone) – see Figure 4.11.
Figure 4.12 plots the correlation between demand and supply
shocks for various countries relative to the Eurozone.
The low or negative demand shock correlations for Slovakia,
Slovenia, the Czech Republic, the UK, Latvia and Lithuania may
be attributable to each country following its own monetary
policy.
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These demand shock correlations could well change sign if
these countries joined the Eurozone.
(ii) Monetary union in Latin America
Within region exports as a share of GDP in Latin America are
compared with the Euro-zone in Figure 4.16.
The very low within region trade levels suggest that monetary
union would not be a good idea.
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Also, there can be no presumption that a Latin American central
bank would have any more inflation-fighting credibility than the
existing central banks in the region.
There is no equivalent of Germany in the region.
Monetary union in Latin America does not look like a good idea.
Some Latin American countries have considered monetary union
with the US in the form of dollarization (i.e., unilateral adoption
of the US dollar).
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(iii) Monetary union in East Asia
The within region trade in East Asia is comparable with that
in the Euro-zone (see Figure 4.17).
The symmetry of the shocks hitting East Asian countries are
also comparable to those hitting the Eurozone countries (see
Figures 4.18 and 4.19).
East Asia does look like a potential candidate for monetary
union. Increasingly, the countries in the region however
would fear domination by China. Hence monetary union is
unlikely in the near future.
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