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January 2012

Lecture 3: Optimum currency areas and

European monetary union

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Overview

The exchange rate and monetary policy  Types of exchange rate regime – what are the choices? Monetary union, optimum currency areas and the

European Union

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The eurozone (17)

1999: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain

2000: Greece 2007: Slovenia 2008: Cyprus, Malta 2009: Slovakia 2011: Estonia Sweden, Denmark, UK opt-out – other 7 have to join San Marino, Monaco and Vatican City – with agreement Andorra, Kosovo and Montenegro – without agreement

(≈“dollarisation”)

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The eurozone today

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Background theory

A quick refresher on basic macroeconomic principles Application of these principles to the choice of exchange

rate regimes Europe’s monetary integration is a history of seeking

exchange rate stability

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The question and the answer

The question: what to do with the exchange rates?

The answer: there is no best arrangement It is a matter of trade-offs

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Three basic principles

Long term: neutrality of money In the long run, money, the price level and the exchange

rate tend to move proportionately

Short term: non-neutrality of money Sticky prices mean real short-run effects

Interest parity condition With integrated capital markets r = r*

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Long-term: neutrality of money (1)

Comparison between France and Switzerland

Growth rate in France less growth rate in Switzerland

Annual averages

-10

-5

0

5

10

15

20

25

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

Money grow th Inflation

Exchange rate

Year to year:nothing really visible

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Long-term: neutrality of money (2)

Annual averages

-10

-5

0

5

10

15

20

25

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004Money grow th Inflation

Exchange rate

Five-year averages

-10

-5

0

5

10

15

20

25

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

Money grow th Inflation

Exchange rate

Five-year averages:something emerges

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Long-term: neutrality of money (3)

Annual averages

-10

-5

0

5

10

15

20

25

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

Money grow th Inflation

Exchange rate

Five-year averages

-10

-5

0

5

10

15

20

25

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

Money grow th Inflation

Exchange rate

Ten-year averages

-10

-5

0

5

10

15

20

251960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

Money grow th Inflation

Exchange rate

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Long-term neutrality of money in AS-AD model

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PPP: an implication of long-term neutrality (1)

Absolute purchasing power parity Based on “law of one price” So long-run equilibrium exchange rate must adjust to

equalise purchasing power of different currencies The real exchange rate:

defined as = EP/P* if absolute PPP, then EP = P* eg, if X is NZ$2.50 and US$2.00 then E = US$2.00/NZ$2.50 = US$0.80/NZ$ for PPP so = 1

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Burgernomics

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PPP: an implication of long-term neutrality (2)

The real exchange rate with relative PPP:

defined as = EP/P*

PPP: E offsets changes in P/P*

so is constant

Equivalently:

or e = п* - п

PΔP

*P*ΔP

EΔE

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PPP: an implication of long-term neutrality (3)

France and Switzerland: averages 1951-2004

2.5

2.4

3.0

Average money growth: France less Switzerland

Average inflation: France less Switzerland

Average appreciation CHF vs. FRF

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PPP: an implication of long-term neutrality (4)

0

100

200

300

400

500

600

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

Nominal Exchange Rate Real Exchange Rate

Germany and the UK (1951-2004)

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Caveat: the Balassa-Samuelson Effect (1)

Consumer price levels in wealthier countries are systematically higher than poorer ones – why?

Most workers in rich countries have higher productivity than in poor countries

But burger flippers have same productivity everywhere (in burgers per hour)

To get burger flippers in rich countries, have to pay more than in poor countries

So burgers cost more in rich countries CPI is made up of:

local goods (which are expensive relative to tradables in rich countries) tradables, which have the same price everywhere

So the price level is higher in more productive, richer, economies

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Caveat: the Balassa-Samuelson Effect (2) – RER () rises with convergence

Average annual changes vis-à-vis the Eurozone (1993-2005, % per annum)

Czech

Rep. Hungary Poland Slovak

Rep.

Real appreciation 4.4 3.4 2.9 3.5

Inflation differential 3.6 10.3 8.7 4.2

Nominal appreciation 0.8 -6.9 -5.8 -0.7

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Short-term non-neutrality of money

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

the interest rate channel (cheaper loans) the credit channel (more liquidity = more credit) the stock market channel (wealth effect) the exchange rate channel (cheaper exports) – very

important channel in open economies

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Short-run AS and the real economy

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Exchange rate regimes and policy effectiveness

Fixed exchange rate no independent

monetary policy money is endogenous

Flexible exchange rate: no effect of fiscal

policy the exchange rate

offsets fiscal policy effects

Interest parity condition r = r*

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Exchange rate regimes and policy effectiveness

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Why does the choice of exchange rate regime matter?

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

In the long run, is independent of E… …because P adjusts

The choice of an exchange rate regime matters in the short run because prices (and wages) are sticky

The choice of exchange rate regime determines the effectiveness of monetary and fiscal policy to absorb shocks

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What’s on the menu?

Free floating Managed floating Target zones Crawling pegs Fixed and adjustable Currency boards Dollarization/euroization Monetary union

Flexible

Fixed

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The choice of an exchange rate regime

The monetary policy instrument: flexible exchange rates can be useful to deal with cyclical disturbances can be politically abused (independent central banks)

The fiscal policy instrument: fixed exchange rates can also deal with cycles, but can also be politicised

(political cycles) deficits can lead to unsustainable public debt

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The Two-Corners Solution (1)

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 (eg, currency boards) are unassailable…..

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….although Argentina’s currency board collapsed in 2002

Not a true 100% backed currency board

Argentine defaulted on external debt in 2002

Unemployment more than 25% Massive capital outflows, runs on

banks Peso depreciated 75% after being

devalued and floated Michael Bleaney (2004), ‘Argentina's

Currency Board Collapse: Weak Policy or Bad Luck?’ The World Economy, 27 (5), 699–714

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Hong Kong currency board 1997-98

Aftermath of 1997 Asian financial crisis, risk re-priced, Asian currencies vulnerable

Hong Kong dollar pegged to US$ through 100% currency board First speculative attack – investors short HK$

HKG raised interest rates Second double-pronged speculative attack – investors short

HK$ and HKG shares to force HKG to float to prevent collapse of stock market HKG raised interest rates And OMO in stock market, bought 40% of shares to defend market,

banned short-selling

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The road to monetary union

EU has also regarded exchange rate volatility as an obstacle to free trade in goods, services, labour and capital

History of European attempts to “fix” cross-rates The European Monetary System, deutschmark bloc and

the 1992-93 exchange rate crises Monetary union (hard pegs, then single currency)

emerged as preferred policy choice

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Benefits and costs of monetary union

The benefits: Eliminate exchange rate uncertainty (promote cross border

trade, investment) Eliminate transactions costs (with single currency) Transparent prices (promote competition) Low, stable inflation (lower nominal interest rates)

The costs: Loss of monetary sovereignty (independent monetary policy

with flexible exchange rate)… …which matters in presence of price and wage stickiness and

asymmetric shocks Risk of sovereign default (more next week)

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Benefits and costs are a function of the number of countries in the monetary union

The benefits: Money exhibits increasing returns to scale (network

externalities) – the more people accept a currency, the more useful it is

A world-wide monetary union (“currency area”) is the way to maximize these benefits

The costs: As size of (currency area) grows, greater diversity of national

macroeconomic conditions Loss of monetary sovereignty (independent monetary policy

with flexible exchange rate)… …and greater likelihood of asymmetric shocks

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The economic toolkit

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

…and so an optimum size for the currency area

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The key is asymmetric shock

The benefits argue for one worldwide currency The costs depend on asymmetric shocks which affect one

country more than others…… …..so that ‘one size’ monetary policy does not fit all

countries Look at asymmetric shocks:

How do they create trouble? What makes them more likely? What makes them less painful?

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A demand shock: how does the exchange rate help?

Supply of domestic goods rises as RER appreciates – profitability increases as some costs tied to foreign prices

Demand for domestic goods falls as RER rises, switch to foreign goods

Could use RER in terms of production costs EW/W*, since costs feed into prices

Need P, W to fall or E to depreciate

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Symmetric shock

Same demand shock in two similar countries that share the same currency and, therefore, exchange rate: no problem.

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Asymmetric shock

Only country A is affected with a common currency: big problem!

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Asymmetric shock: response 1

Country A wants a depreciation to λ1. With sticky prices, country B faces inflationary excess demand. No ‘one size fits all’.

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Asymmetric shock: response 2

Depreciate common currency to ‘correct’ average RER, λ2: excess supply in

country A, excess demand in country B. Still no one sizes fits all.

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Asymmetric shock: response 2 (cont’d)

Excess supply in country A -> recession, eventually prices fall; excess demand in

country B -> inflation, prices rise. Equilibrium restored.

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Implications of asymmetric shocks

Both countries are hurt when they share the same currency ….also if a symmetric shock creates asymmetric effects

(because economic structures different) This is an unavoidable cost So:

What reduces the incidence of asymmetric shocks? or What makes it easier to cope with shocks when they occur?

The analysis develops six OCA criteria

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Six OCA criteria

Three classic (economic) criteria Labour mobility (Mundell) Product diversification (Kenen) Openness (McKinnon)

Three political criteria Fiscal transfers Homogeneity of preferences Solidarity

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Criterion 1: labour mobility (1)

In an OCA, labour moves easily across national borders, from country A (recession) to B (inflation). Equilibrium restored at λ2.

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Criterion 1: labour mobility (2)

In an OCA, labour moves easily across national borders…..

…..but: labour mobility is easy within national borders (culture,

language, legislation, welfare, etc) financial vs physical capital – financial capital mobile, but

workers need physical capital as well, immobile in short run

in presence of country specialization, labour skills also matter

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Criterion 2: production diversification

Most shocks associated with changes in spending patterns, new technologies which bring about new product choices

If countries’ production and exports are widely diversified and of similar structure, then…..

…there are few asymmetric shocks and each is likely to be of small concern

Such countries form an OCA

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Criterion 3: 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

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Criterion 4: fiscal transfers

Countries that agree to compensate each other for adverse shocks 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

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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 (product diversification)

criterion is satisfied

May also help for asymmetric shocks: better understanding of partners’ actions encourages transfers

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Criterion 6: solidarity

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 Greek bail out?

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Very Product

Open differentiation (McKinon) (Kenen)

Low likelihood of asymmetric shocks

YES: NO: OCA Need adjusment

Labour

mobility (Mundell)

YES: NO: OCA need adjustnent

Flexible wages and prices

YES: NO: OCA need political

support

Homogeneity Transfers of Solidarity

preferences

A summary

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Is Europe an OCA?

A synthetic OCA index:

How much should countries have adjusted ER vis-à-vis DM in response to asymmetric shocks?

The bigger the shocks and the more adjustment needed, the higher the index

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Inside the OCA Index: labour mobility (1)

The labour mobility criterion cannot be black-and-white The migration response to economic incentives must factor

in many costs: moving costs risk of becoming unemployed longer run career opportunities family prospects eligibility to welfare taxation cultural/linguistic differences national attachment

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Inside the OCA Index: labour mobility (2)

An international comparison suggests that labour mobility is low in Europe

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

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Inside the OCA Index: diversification

Trade dissimilarity index: How dissimilar is trade

from Germany (benchmark)?

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

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Inside the OCA Index: openness

Most EU countries are very open (ratio of X+M to GDP) The McKinnon criterion is broadly satisfied

Austria 52.3 Cyprus 48.3 Denmark 42.8Belgium 87.2 Czech Republic 76.0 Sweden 43.9Finland 35.4 Estonia 92.0 UK 27.9France 27.2 Hungary 70.1Germany 39.9 Latvia 55.0 Bulgaria 65.9Greece 25.5 Lithuania 56.9 Croatia 54.4Ireland 72.6 Malta 81.8 Romania 39.3Italy 27.9 Poland 40.9 Turkey 36.5Luxembourg 133.3 Slovak Republic 83.6Netherlands 66.4 Slovenia 63.1Portugal 36.2 US 13.8Spain 29.5 EU-25 10.7 Japan 13.5

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Is Europe an OCA: a complication…..

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

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Inside the OCA Index: political criteria

The EU does not satisfy the transfer criterion The overall EU budget is entirely used for agriculture,

cohesion, administration Net transfers not related to pc GDP

Little is known about: Homogeneity of preferences Commonality of destiny…although most public opinion in

favour of EU

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Commonality of destiny: poll results

0% 20% 40% 60% 80% 100%

UK FI

AT SE

DK IE

NL

FR EE

LT MT

PT LV

LU CY DE

CZ PL

BE EL

ES IT

HU SK SI

EU25

For Against Don't know

Do you support European political union?

(Eurobarometer, 2005)

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Overall?

The OCA glass is half full, or half empty

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History never ends: the endogeneity of OCA criteria

Living in a monetary union may help fulfil 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?

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Endogeneity: 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

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Endogeneity: will diversification grow or decline?

Argument 1: intra-industry trade will grow Argument 2: specialisation will increase No firm conclusion so far

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Endogeneity: will economies become more open?

Little evidence that reducing exchange rate volatility increases trade

Mounting evidence that eliminating exchange rate volatility by adopting a common currency increases trade a lot: estimates range from 50 per cent to 100 per cent the ‘border effect’ provides similar estimates – without common

currency, border prices can be very different (eg, US – Canada)

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Endogeneity: are the political criteria endogenous?

Transfers: currently no support for more taxes to finance

transfers

Homogeneity of preferences: no presumption that it will change soon

Commonality of destiny: no presumption that it will change soon

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Conclusions

Basic principles: Long-term neutrality of money (PPP) Short-term monetary policy matters, with sticky prices Choice of exchange rate regime impacts relative effectiveness of

monetary and fiscal policy

EMU seen as the solution for the EU The OCA criteria do not send a clear signal: The OCA criteria tell us where the costs will arise:

labour markets and unemployment political tensions in presence of deep asymmetric shocks

But real problem in the current EU crisis has been reliance on fiscal policy and government deficits and insolvency – agenda for Lecture 4