Chapter 2:The Theory of Optimum Currency

Areas: A Critique

De Grauwe:Economics of Monetary Union

• Critique of OCA-theory can be formulated at three different levels:– How relevant are the differences between

countries? Should we worry?– Is national monetary policy (including exchange

rate policy) effective?– How credible are national monetary policies?

How relevant are the differences between countries?

Should we worry?

Let’s analyze these differences

1. How likely are asymmetric demand shocks when integration increases?

There exist two views– Optimistic view:

• intra-industry trade leads to similar specialization patterns• Integration leads to more equal economic structures and

less asymmetric shocks

– Pessimistic view: • economies of scale lead to agglomeration effects and

clustering• Integration leads to more asymmetric shocks

Figure 2.1: Optimistic view

symmetry

Trade integration

Figure 2.2: Pessimistic view

symmetry

Trade integration

• Which view is likely to prevail?– A little bit of both – But even if pessimistic view prevails, agglomeration

effect will be blind to national borders– Then asymmetric shocks cannot be dealt with by

national monetary policies– Empirical evidence of Frankel and Rose favours

optimistic view– Role of services: they are increasingly important,

and less subject to economies of scale

2. Institutional differences in the labour market

• Institutional differences in labour markets create asymmetries in the transmission of shocks

• Some of these differences disappear in the monetary union– Monetary union puts pressure on trade unions

• Other differences will remain in place

3. Different legal systems and financial markets

• The reduction of inflation differentials in monetary union leads to institutional convergence– e.g. maturity structure in bond markets converges

• However, not all institutional differences will disappear

• Legal systems remain very different creating ‘deep’ differences in financial systems

– Cfr. Difference between Anglo-Saxon and Continental European financing of firms

4. Asymmetric shocks and the nation-state

• Existence of nation-states is a source of asymmetric shocks– Taxation and spending remains in realm of

national sovereignty– Social policies are national– Wage policies

• This creates a need for further political integration in a monetary union

Recent divergencies in the Eurozone

Nominal wage increases (in %)

0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004 2005 2006

per

cen

t in

crea

se

Germany

Eurozone

US

UK

Wage policies in Germany

Since 2000 declining nominal growth of wages in Germany

Induced by the need to restore previous losses of competitiveness

And a desire to face competition from low wage countries

Germany improved its competitive position vis a vis the rest of the Eurozone

Note also contrast with US and UK

Dramatic effect on competitive positions within the Eurozone

Index is based on ULC (takes into account productivity differentials)

Germany improves its competitive position

At the expense of many other Eurozone countries

Real effective exchange rates (ULC) within Eurozone

80

85

90

95

100

105

110

115

120

1998 1999 2000 2001 2002 2003 2004 2005 2006

UL

C

BLEU

Germany

Greece

Spain

France

Ireland

Italy

Netherl

Austria

Portugal

Finland

5. Do differences in growth rates matter?

• Countries with low level of development and high economic growth will not be constrained in monetary union

• Capital market integration may give a boost to the growth in countries with low level of development

How effective are national monetary policies?

• The question we analyse here is whether national monetary policies are effective instruments to correct for asymmetric disturbances.

• Two disturbances are analyzed– Permanent asymmetric demand shock– Temporary asymmetric demand shock

Permanent asymmetric demand shocks

• These were analysed in the previous chapter• These require a change in relative prices• Such a relative price change cannot be

achieved by monetary policies

Figure 2.7: Price and cost effects of a national monetary policy

PF

YF

DF

D’F

SF(W1)

S’F(W2)

F

F’

After monetary expansion real wage declines

Workers will want to be compensated by higher nominal wage

Supply shifts upwards thereby reducing output effect of monetary expansion

Effectiveness of monetary policy is reduced

It does not make a difference whether country is in MU

However

• Monetary expansion can, however, sometimes make the dynamics towards new equilibrium less costly than alternative policy strategies.

• The latter is typically more deflationary and leads to larger output losses

Adjustment through deflation

Adjustment through monetary expansion

P

Y

P

Y

National monetary policies to stabilize for temporary asymmetric demand shocks

• Many demand shocks are temporary. For example, business cycle shocks

• These business cycle shocks can be asymmetric

• The issue that arises here is one of macroeconomic stabilization. Let us return to figure 1.1 of the previous chapter

PF P

G

YFYG

France Germany

Figure 1.1: Aggregate demand and supply in France and Germany

DF

DG

SF

SG

• We now interpret this figure as representing completely asynchronous business cycle shocks – i.e. when there is a recession in France there is a

boom in Germany. In the next period, it will then be the other way around with a boom in France and a recession in Germany.

• If these two countries form a monetary union they have a problem: The common central bank is paralysed: – If it lowers the interest rate to alleviate the French

problem, it will increase inflationary pressures in Germany

– If it raises the interest rate to counter the inflationary pressures in Germany it will intensify the recession in France

• Since the shocks are temporary wage flexibility and mobility of labour cannot be invoked to solve this problem

• In a monetary union there is simply no solution to this problem: the common central bank cannot stabilize output at the country level; it can only do this at the union level

• When France and Germany, however, keep their own money they have the tools to stabilize output at the national level – Thus when France is hit be a recession the French

central bank can stimulate aggregate demand by reducing the interest rate and allowing the French Franc to depreciate

– Similarly, when Germany experiences a boom, its central bank can raise the interest rate and allow the currency to appreciate to dampen the boom

• In a monetary union these countries loose their ability to do so

• The question that arises here is how effective these stabilization policies are at the national level

• We postpone the discussion here, and we will return to it later

• There we will show that sometimes too active a use of monetary stabilization can lead to new sources of instability

Currency depreciations to correct for different policy preferences

• In Keynesian world exchange rate adjustment allow countries to select desired point on inflation-unemployment trade-off.

• Not so in monetarist world where long-run Phillips curve is vertical

Figure 2.7: Monetary Union in a world of vertical Phillips Curves

Germany

Italy

.

Gp GU

.

Ip IU

0

0

.

Gw

.

Iw

.

Gq

.

Iq

An aside: Productivity and inflation in monetary union

The Balassa-Samuelson effect

• Inflation differentials in monetary union can be significant

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

FIN GER AUT FR BEL EU-12

IT NL LUX PT SP GRE IRL

Infl

ati

on

(%

)

Average yearly inflation in Eurozone countries, 1999-2005 (%)

Balassa-Samuelson model• Inflation in France• Inflation in Ireland(we assume that inflation in non-tradables is equal to

wage inflation)• Inflation rates in tradable goods sectors are equal • This leads to • Assuming that differences in wage increases reflect

differences in productivity growth we obtain

• Inflation in Ireland exceeds inflation in France if Irish productivity increases faster than French productivity

FFF wpcp...

)1(

III wpcp...

)1(

IF pp..

))(1(....IFIF wwpccp

))(1(....

IFIF qqpccp

Should wage bargaining be centralized in monetary union?

• This implies that if productivity growth is higher in Ireland than in France, wages should increase faster in Ireland than in France

• If centralized wage bargaining leads to equal wage increases, France looses competitiveness

IFIF qqww

National monetary policies, time consistency and credibility

• Credibility affects the effectiveness of policies• We use Barro-Gordon model• We first develop closed-economy version• Then we develop two-country version

Barro-Gordon model

•There is a short-term trade-off between inflation and unemployment for every level of expected inflation•The vertical line represents the 'long-term' vertical Phillips curve. It is the collection of all points for which •This vertical line defines the natural rate of unemployment UN

..epp

Figure 2.9: The Phillips curve and natural unemployment .p

2

.p

1

.p

.

2

.

ppe

.

1

.

ppe

NU U

0

.

ep

U

I3

I2

I1

Figure 2.12: The preferences of the authorities

p • Indifference curves are concave• Slope expresses relative importance attached to fighting inflation versus fighting unemployment

Figure 2.13: The preferences of the authoritiesp

U

I3

I2

I1

U

‘Hard-nosed’ government ‘Wet’ government

I1

I2

I3

p

•‘Hard-nosed’ government attaches a lot of weight to fighting inflation

•‘Wet’ government attaches a lot of weight to fighting unemployment

Figure 2.14: The equilibrium inflation ratep

U

1p

UN

1ppe

0ep

B

C

E

A

•Announcing a zero inflation policy is not credible because authorities prefer point B to A•Rational agents know this•Therefore they will set their expectations about inflation such that authorities have no incentive anymore from the announced inflation rate•This is achieved in point E, which is the rational expectations time consistent equilibrium

Figure 2.15: Equilibrium with ‘hard-nosed’ and ‘wet’ governments

p

U U

‘Hard-nosed’ government ‘Wet’ government

p

UN UN

AB

E

A

B

E

•‘Hard-nosed’ government achieves lower inflation equilibrium than ‘wet’ government without imposing more unemployment in the long run

Figure 2.16: Equilibrium and the level of natural unemployment

p

UUN

AB

E

E’

U’N

Equilibrium inflation rate also depends on the level of the natural unemployment

The Barro-Gordon model in an open economy

• We add the purchasing power parity condition to link the inflation rates of two countries, called Germany and Italy, i.e.

GI ppe

How can Italy reach a more attractive (lower) inflation equilibrium?

UG UI

Germany Italy

Ip

A

E

C

G

FGp

Gp

Fixing the exchange rate of the lira with the mark is not credible, because Italian authorities have an incentive to create surprise inflation (devaluation)

• Only by abolishing the Italian central bank and adopting the mark can Italy escape from high inflation equilibrium

• This is also what countries that decide to “dollarize” hope to achieve

• Monetary union is more complicated because in monetary union both central banks decide jointly and a new currency is created

• This leads to problem in that new central bank may not have the same reputation as the German Bundesbank

• The latter is reluctant to join

Optimal stabilisation and monetary union

A

B

C

B’

U

UU

UN U1 U2

π1

UL

• Dotted line is optimal stabilisation line• Without stabilisation unemployment would increase to B’ after shock• With stabilisation increase in unemployment is limited to B• The price paid is higher inflation • Price increases with steepness of stabilisation line

Figure 2.18: Optimal stabilization in country with high preference for unemployment stability

Figure 2.19: Optimal stabilization in country with low preference for unemployment stability

A

B

CB’

U

UU

UN U1 U2

π2

• This country cares less about unemployment• Same shock will lead to stronger increase in unemployment• But less inflation

• When countries join a monetary union, they indeed loose an instrument of policy that allows them to better absorb temporary (asymmetric) shocks

• However, this loss may not always be perceived to be very costly because countries that actively use such stabilization policies also pay a price in terms of higher long-term rate of inflation

Cost of monetary union and openness

PO PC

YOYC

DO

SO

DC

SC

Figure 2.20: Effectiveness of currency depreciation as a function of openness

Very open country Relatively closed country

Figure 2.21: The cost of a monetary union and the openness of a country

Cost(% of GDP)

Trade (% of GDP

• Countries that are very open experience less costs of joining a monetary union compared to relatively closed economies

• The reason is that relatively open economies loose an instrument of policy that is relatively ineffective