Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 12 Optimum Currency Areas Theory and Politics of Eropean Integration

Theorie und Politik der Europäischen Integration

Prof. Dr. Herbert Brücker

Lecture 12

Optimum Currency Areas

Theory and Politics of Eropean Integration

Theory and Politics of European Integration Optimal Currency Areas

Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker

Last Lecture

• A monetary history of Europe· Metallic money· Monetary equilibrium under gold standard (Hume’s mechanism)· The interwar period· The post-war period: · From Bretton Woods to Snake and Super-Snake to EMU

• The choice of exchange regimes· Exchange rate and monetary policy· The range of exchange rate policies· Choices

– Criteria– Fix or float?– Regional arrangements



This lecture

• Leftovers from the last lecture• Choice of exchange rate regimes

• Optimal currency areas• Theory

· Adjustment under asymmetric shocks· With and without currency union

• Six criteria for OCA• Do the members of the Eurozone fullfill criteria

for optimal OCA?



Long term neutrality implication: PPP

• The real exchange rate• Defined as = EP/P*• E = nominal exchange rate; P = domnestic price;

P* = foeign price• Purchasing Power Parity (PPP): E offsets changes in P/P*• So is constant

• Many caveats, though:• PPP seems to hold in the long run, but not in the

short and medium run



Short term non-neutrality of money

• From AD-AS: the short-run AS schedule• So monetary policy matters in the short run• Channels of monetary policy

• The interest rate channel• The credit channel• The stock market channel• The exchange rate channel



Monetary policy in the IS-LM model

A

CB

D

IS

IS‘

LM LM‘

Output-gap(Actual-Trend GDP)

foreignlevel

interest rate




A

CB

D

IS

IS‘

LM LM‘


Foreignlevel

interest rate

1. increase in money supply moves LM to LM‘,2. interst rates declines initially to B, 3. spending expands and economy moves to C4. capital flows out until interest rate is back to international level




A

CB

D

IS

IS‘

LM LM‘


Foreignlevel

interest rate

Flexible exchange rate:• currency depreciates• current account improves (IS shifts to IS‘)• output moves eventually to D




A

CB

D

IS

IS‘

LM LM‘

output-gap(Actual-Trend GDP)

Foreignlevel

interest rate

Fixed exchange rate:• Central Bank must intervene in exchange market• money supply shrinks until LM curve shifts back from LM‘ to LM and output to A




A

CB

D

IS

IS‘

LM LM‘

output-gap(Actual-Trend GDP)

Foreignlevel

interest rate

Thus, there is no room for monetary policy with a fixed exchange rate!



Fiscal policy in the IS-LM model

A

B

C

IS

IS‘

LM LM‘


Foreignlevel

interest rate




A

B

C

IS

IS‘

LM LM‘


Foreignlevel

1. Fiscal policy shifts IS curve to IS’.2. LM stays where it is.3. Output moves to B.4. The interest rate rises above foreign level.5. Capital flows in to restore interest parity

interest rate




A

B

C

IS

IS‘

LM LM‘


Foreignlevel

Fixed exchange rate:• Central Bank intervenes to prevent currency appreciation• sells money such that increased money supply shifts LM to LM’• economy moves eventually to point C

interest rate




A

B

C

IS

IS‘

LM LM‘


Foreignlevel

Flexible exchange rate:• Capital flows in and currency appreciates• Current account worsens• Demand declines• Eventually, IS’ shifts back to IS and the economy back to A

interest rate




A

B

C

IS

IS‘

LM LM‘


Foreignlevel

Thus, fiscal policy does only work under fixed exchange rates in small open economnies

interest rate



Exchange rate regimes and policy effectiveness

Monetary policy

Fiscal policy

Fixed exchange rate

Ineffective Effective

Flexible exchange rate

Effective Ineffective



When does the regime matter?

• In the short run, changes in E are mirrored in changes in = EP/P*: P and P* are sticky

• In the long run, is independent of E: P adjusts• If P is fully flexible, the long run comes about

immediately and the nominal exchange rate does not affect the real economy

• Put differently, the choice of an exchange rate regime has mostly short run effects because prices are sticky



What’s on the menu?

• Free floating (e.g. US, Eurozone)• Managed floating (e.g. Japan)• Target zones (e.g. ‘snake’)• Crawling pegs (e.g. Poland under transition)• Fixed and adjustable (e.g. Bretton Woods)• Currency boards (e.g. Estonia, Lithuania in 1990s)• Dollarization/Euroization• Monetary union



The choice of an exchange rate regime

• The monetary policy instrument• Can be useful to deal with cyclical disturbances• Can be misused (inflation)

• The fiscal policy instrument• Can also deal with cycles but is often politicized• Can be misused (public debts, political cycles)

• Exchange rate stability• Freely floating exchange rates move “too much” • Fixed exchange rates eventually become misaligned



The old debate: fixed vs. float

• The case for flexible rates• With sticky prices, need exchange rate flexibility to deal

with shocks• Remove the exchange rate from politicization• Monetary policy is too useful to be jettisoned

• The case for fixed rates• Flexible rates move too much (financial markets are often

hectic)• Exchange rate volatility: a source of uncertainty• A way of disciplining monetary policy• In presence of shocks, always possible to realign



The new debate: the two-corners solution

• Only pure floats or hard pegs are robust• Intermediate arrangements (soft pegs) invite government

manipulations, over or under valuations and speculative attacks

• Pure floats remove the exchange rate from the policy domain

• Hard pegs are unassailable (well, until Argentina’s currency board collapsed…)

• In line with theory• Soft pegs are half-hearted monetary policy commitments,

so they ultimately fail



The two-corners solution and the real world

• Fear of floating• Many countries officially float but in fact

intervene quite a bit• Fear of fixing

• Many countries declare a peg but let the exchange rate move out of official bounds



Fear of floating

80.00

90.00

100.00

110.00

120.00

130.00

140.00

1999M1 1999M7 2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7

Denmark (vis a vis €)Sweden (vis a vis €)Switzerland (vis a vis €)Korea (vis a vis $)



The two-corners solution and the real world

• Fear of floating is deeply ingrained in many

European countries

• Fear of fixing partly explains the disenchantment

with the EMS and some reluctance towards

monetary union



Conclusions

• A menu hard to pick from: trade-offs are everywhere• All of this takes the view from a single country• Systems involve many countries and rest on agreed upon

rules, including mutual support• Since the end of Bretton Woods, there is no world monetary

system• This leaves room for regional monetary systems. Enters

Europe’s experience



Optimal currency areas (OCA)



A good question, no simple answer

• Should curreny area borders coincide with national borders?

• If not, how best to delineate currency areas?

• What economic criteria should be used?



The economic toolkit

• There must be benefits and costs involved in adopting a common currency

• The solution has to involve trading off these benefits



In a nutshell

• The benefits• Money exhibits increasing returns to scale

(network externalities)• The world is the way to maximize these benefits

• The costs• Loss of monetary and exchange rate instruments• Matters in presence of:

· Price and wage stickiness· Asymmetric shocks



Focusing on costs

• Start with the idea that benefits argue for one worldwide currency

• Ask why not• Look at the costs• No precise way of estimating costs and benefits so,

in the end, a matter of judgement• Look at asymmetric costs

• How they create trouble• What makes them more likely• What makes them less painful



Asymmetric shocks

• Simplest example: an adverse demand shock: how can the exchange rate help?



Asymmetric shocks


If domestic prices and wages are sticky, adverse

demand shock will reduce production to

C if exchange rate does not adjust



Asymmetric shocks


If exchange rate adjusts, production

declines to D.



Asymmetric shocks: adverse demand shock in 2 country CU




No currency union case:Real exchange rate declines in country A to λ1, production declines to B, country B remains unaffected




Currency union case:Central Bank let currency decline to λ2, production declines in country A to C, increases in country B to D‘



Asymmetric shocks: adverse demand shock in 2 country CUThis creates inflationary pressures in B (difference between D and D’). Eventually, after wage and price adjustment, country A will move to B and country B to A



Implications of asymmetric shocks

• Thus, both countries are hurt when they share the same currency

• Also the case when a symmetric shock creates asymmetric effects

• This is an unavoidable cost of a currency area



Six critieria for a optimal currency area

• Next questions:• What reduces the incidence of asymmetric shocks?• What makes it easier to cope with shocks when they occur

• The analysis develops six criteria for an optimal currency area (OCA)• Three economic

· labour mobility· diversion· trade openness

• Three political· transfers· homogeneous preferences· Common destiny



Criterion 1 (Mundell): Labour mobility

• In an OCA labour moves easily across national borders.

• Caveats• Labour mobility is easy within national borders (culture, language, legislation,

welfare, etc…), but much less so across national borders

• Capital mobility: difference between financial and physical capital

• In case of country specialization, skills also matter and hinder labour mobility



Criterion 2 (Kenen): Production diversification

• Countries whose production and exports are widely diversified and of similar structure form an OCA.

• Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern



Criterion 3 (McKinnon): Openness

• Countries which are very open to trade and trade heavily with each other form an OCA.

• Distinguish between traded and non-traded goods• Traded good prices are set worldwide• A small economy is price-taker, so the exchange rate

does not affect competitiveness

• In the limit, if all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness



Criterion 4: Fiscal transfers

• Countries that agree to compensate each other for adverse shock form an OCA.

• Transfers can act as an insurance that mitigates the costs of an asymmetric shock

• Transfers exist within national borders• Implicitly through the welfare system• Explicitly in federal states



Criterion 5: Homogeneous preferences

• Countries that share a wide consensus on the way to deal with shocks form an OCA.

• Matters primarily for symmetric shocks• Prevalent when the Kenen criterion is satisfied

• May also help for asymmetric shocks• Better understanding of partners’ actions• Encourages transfers



Criterion 6: Commonality of destiny

• Countries that view themselves as sharing a common destiny better accept the costs of operating an OCA.

• A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interests• This calls for accepting such economic costs in the

name of a higher purpose



Is Europe an OCA?

• A synthetic OCA index:

How much of a currency appreciation/devaluation vis-à-vis the DM is needed to keep economic conditions unchanged?



Is Europe an OCA?

• Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate



Inside the OCA index: Openness

• Most EU countries are very open: The McKinnon criterion is broadly satisfied



Inside the OCA index: Diversification

• Most EU countries have a diversified production structure (intra-industry trade dominates)

• The Kenen criterion is broadly satisfied and well explains which countries joined the euro area



Inside the OCA index: Labour mobility (1)

• The labour mobility criterion cannot be black-and-white

• The migration response to economic incentives must consider many costs:• Moving costs• Risk of becoming unemployed• Longer run career opportunities• Family prospects• Eligibility to welfare• Taxation• Cultural/linguistic differences• National attachment




• An international comparison suggests that labour mobility is low in Europe• Across

countries




• An international comparison suggests that labour mobility is low in Europe• Across

countries• Even within

countries




• Low labour mobility implies that unemployment bears much of the burden of adjustment to shocks

• An US-EU comparison



Inside the OCA index: Transfers

• The EU does not satisfy the transfer criterion

• The overall EU budget• is low, capped at 1.27% of EU GDP• entirely used for administration, CAP,

regional and structural funds• These funds do not vary with the

business cycle and are not earmarked to address asymmetric shocks



Inside the OCA index: Homogeneity of preferences

• Preferences could affect the role of monetary and fiscal policies to address external shocks

• Little is known about this criterion



Inside the OCA index: Commonality of destiny

• Little is known about this criterion

• Public opinion polls do not reveal deep opposition to EU institutions



Overall

• The OCA glass is half full, or half empty



History never ends: the endogeneity of OCA criteria

• Living in a monetary union may help fulfill the OCA criteria over time

• Would the US be an OCA without a single common currency?

• Will the existence of the EURO area change matters too ?



Will trade deepen?

• Little evidence that reducing exchange rate volatiliy increases trade

• Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot• Estimates range from 50% to 100%• The “border effect” provides similar estimates



Will diversification grow or decline?

• Argument 1: intra-industry trade will grow

• Argument 2: specialization will increase

• No firm conclusion so far



EMU and labour markets

• Mobility may not change much, but wages could become less sticky

• Two views:• The virtuous circle: labour markets respond to enhanced

competition by becoming more flexible• The hardening view: labour markets respond to enhanced

competition by increasing protective measures that raise stickiness

• The jury is still out



Are the other criteria endogenous?

Transfers• Currently no support for more taxes fo finance transfers

Homogeneity of preferences• No presumption that it will change soon

Commonality of destiny• No presumption that it will change soon



In the end

• Monetary union is not only about economics

• The OCA criteria do not send a clear signal• The EU is not a perfect OCA• A monetary union may function, at cost

• The OCA criteria tell us where the costs will arise:• Labour markets and unemployment• Political tensions in presence of deep asymmetric shocks



Next lecture

• European Monetary Union (EMU)

• Reading:• Baldwin/Wyplosz (2009), Chs. 17-18

• Discussion of exam

Documents

Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 12 Optimum Currency Areas Theory and Politics of Eropean Integration