Economic Monetary UnionOptimal Currency Area Theory

Costs & Benefits of EMUAncient Rome

Lecture 6

Stephen Kinsellawww.stephen kinsella.net

Background

Free Movement of Capital

Coordination of Ec. PolicyIndependent Central Banks

The EuroCommon Monetary Policy

The ECB

1.

2.

3.

1990––1999

Benefits of a Single Currency

Inflation Convergence Within Six Original EMS Members, 1978-2000

Less transactions costs

More price transparency

Less uncertainty

More economic growth

So ....

Elimination of foreign exchange markets within union eliminates cost of exchanging one currency into another

Cost reductions amount to 0.25 to 0.5% of GDP

Less transactions costs

One common unit of account facilitates price comparisons

Consumers “shop around” more

Competition increases

Prices decline and consumers gain

Price transparency

Large price differentials continue to exist

These have to do with

transactions costs at the retail level

and product differentiation

Will euro increase price transparency in a significant way?

Handout

Less Uncertainty

Does the decline in exchange risk increase

welfare?

P P

Q Q

P1 P1P2

P3

MC MC

X

YA

A

Price Certainty Price Uncertainty

Profit = A-(Area of ) Profit = A-(Area of )+X+Y

Profits are higher on average when there is price certainty

Welfare will then depend on degree of risk aversion

If risk aversion sufficiently high price certainty is preferred by firms

More economic growth

Empirical evidence about monetary

union and growth

Next WeekBenefits & Costs of a Single Currency

We’ll develop Optimal Currency Area Theory

Read

Pelkmans, J. European Integration: Methods and Economic Analysis 1st ed., pgs. 83–104 and 133–155. 337.142 PEL.