Optimum currency areas and European monetary union

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University of Canterbury course ECON339: Lecture 3

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Optimum currency areas and European monetary union

  1. 1. ECON339 EURO339 Lecture 3: Optimum currency areas andEuropean monetary union January 2012
  2. 2. ECON339 / EURO339Overview  The exchange rate and monetary policy  Types of exchange rate regime – what are the choices?  Monetary union, optimum currency areas and the European Union 2
  3. 3. ECON339 / EURO339The eurozone (17)  1999: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxe mbourg, 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”) 3
  4. 4. ECON339 / EURO339The eurozone today 4
  5. 5. ECON339 / EURO339Background 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 5
  6. 6. ECON339 / EURO339The 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 6
  7. 7. ECON339 / EURO339Three 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* 7
  8. 8. ECON339 / EURO339Long-term: neutrality of money (1) Annual averages Comparison between 25 France and Switzerland 20 Growth rate in France less 15 growth rate in Switzerland 10 5 0 Year to year: -5 nothing really visible -10 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Money grow th Inflation Exchange rate 8
  9. 9. ECON339 / EURO339Long-term: neutrality of money (2) Annual averages Five-year averages25 2520 2015 15 Five-year10 10 averages: 5 5 something 0 0 emerges -5 -5-10 -10 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Money grow th Inflation Money grow th Inflation Exchange rate Exchange rate 9
  10. 10. ECON339 / EURO339Long-term: neutrality of money (3) Annual averages Five-year averages Ten-year averages25 25 2520 20 2015 15 1510 10 10 5 5 5 0 0 0 -5 -5 -5-10 -10 -10 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Money grow th Inflation Money grow th Inflation Money grow th Inflation Exchange rate Exchange rate Exchange rate 10
  11. 11. ECON339 / EURO339Long-term neutrality of money inAS-AD model 11
  12. 12. ECON339 / EURO339PPP: an implication of long-termneutrality (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 12
  13. 13. ECON339 / EURO339 Burgernomics
  14. 14. ECON339 / EURO339PPP: an implication of long-termneutrality (2)  The real exchange rate with relative PPP:  defined as = EP/P*  PPP: E offsets changes in P/P*  so is constant  Equivalently: ΔE ΔP * ΔP E P* P  or e = п* - п 14
  15. 15. ECON339 / EURO339PPP: an implication of long-termneutrality (3) France and Switzerland: averages 1951-2004 Average money growth: France less Switzerland 2.5 Average inflation: France less Switzerland 2.4 Average appreciation CHF vs. FRF 3.0 15
  16. 16. ECON339 / EURO339PPP: an implication of long-termneutrality (4) 600 500 Germany and the 400 UK (1951-2004) 300 200 100 0 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 Nominal Exchange Rate Real Exchange Rate 16
  17. 17. ECON339 / EURO339Caveat: 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 17
  18. 18. ECON339 / EURO339Caveat: the Balassa-Samuelson Effect(2) – RER ( ) rises with convergence Average annual changes vis-à-vis the Eurozone (1993-2005, % per annum) Czech Hungary Poland Slovak Rep. Rep.Real appreciation 4.4 3.4 2.9 3.5Inflation differential 3.6 10.3 8.7 4.2Nominal appreciation 0.8 -6.9 -5.8 -0.7 18
  19. 19. ECON339 / EURO339Short-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 19
  20. 20. ECON339 / EURO339Short-run AS and the real economy 20
  21. 21. ECON339 / EURO339Exchange rate regimes and policyeffectiveness 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* 21
  22. 22. ECON339 / EURO339Exchange rate regimes and policyeffectiveness 22
  23. 23. ECON339 / EURO339Why does the choice of exchangerate 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 23
  24. 24. ECON339 / EURO339What’s on the menu?  Free floating Flexible  Managed floating  Target zones  Crawling pegs  Fixed and adjustable  Currency boards  Dollarization/euroization  Monetary union Fixed 24
  25. 25. ECON339 / EURO339The choice of an exchange rateregime  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 25
  26. 26. ECON339 / EURO339The 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….. 26
  27. 27. ECON339 / EURO339….although Argentina’s currency boardcollapsed 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), „Argentinas Currency Board Collapse: Weak Policy or Bad Luck?‟ The World Economy, 27 (5), 699–714 27
  28. 28. ECON339 / EURO339Hong 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 28
  29. 29. ECON339 / EURO339The 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 29
  30. 30. ECON339 / EURO339Benefits and costs of monetaryunion 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) 30
  31. 31. ECON339 / EURO339Benefits and costs are a function of thenumber 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 31
  32. 32. ECON339 / EURO339The economic toolkit  There must be benefits and costs involved in adopting a common currency…  …and so an optimum size for the currency area 32
  33. 33. ECON339 / EURO339The 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? 33
  34. 34. ECON339 / EURO339A demand shock: how does theexchange 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 34
  35. 35. ECON339 / EURO339Symmetric shock Same demand shock in two similar countries that share the same currency and, therefore, exchange rate: no problem. 35
  36. 36. ECON339 / EURO339Asymmetric shock Only country A is affected with a common currency: big problem! 36
  37. 37. ECON339 / EURO339Asymmetric shock: response 1 Country A wants a depreciation to λ1. With sticky prices, country B faces inflationary excess demand. No „one size fits all‟. 37
  38. 38. ECON339 / EURO339Asymmetric 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. 38
  39. 39. ECON339 / EURO339Asymmetric shock: response 2(cont’d)Excess supply in country A -> recession, eventually prices fall; excess demand in country B -> inflation, prices rise. Equilibrium restored. 39
  40. 40. ECON339 / EURO339Implications 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 40
  41. 41. ECON339 / EURO339Six OCA criteria  Three classic (economic) criteria  Labour mobility (Mundell)  Product diversification (Kenen)  Openness (McKinnon)  Three political criteria  Fiscal transfers  Homogeneity of preferences  Solidarity 41
  42. 42. ECON339 / EURO339Criterion 1: labour mobility (1)In an OCA, labour moves easily across national borders, from country A (recession) to B (inflation). Equilibrium restored at λ2. 42
  43. 43. ECON339 / EURO339Criterion 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 43
  44. 44. ECON339 / EURO339Criterion 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 44
  45. 45. ECON339 / EURO339Criterion 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 45
  46. 46. ECON339 / EURO339Criterion 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 46
  47. 47. ECON339 / EURO339Criterion 5: homogeneouspreferences  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 47
  48. 48. ECON339 / EURO339Criterion 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? 48
  49. 49. ECON339 / EURO339A summary 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 49
  50. 50. ECON339 / EURO339Is 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 50
  51. 51. ECON339 / EURO339Inside 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 51
  52. 52. ECON339 / EURO339Inside 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 52
  53. 53. ECON339 / EURO339Inside 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 53
  54. 54. ECON339 / EURO339Inside 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 42.8 Belgium 87.2 Czech Republic 76.0 Sweden 43.9 Finland 35.4 Estonia 92.0 UK 27.9 France 27.2 Hungary 70.1 Germany 39.9 Latvia 55.0 Bulgaria 65.9 Greece 25.5 Lithuania 56.9 Croatia 54.4 Ireland 72.6 Malta 81.8 Romania 39.3 Italy 27.9 Poland 40.9 Turkey 36.5 Luxembourg 133.3 Slovak Republic 83.6 Netherlands 66.4 Slovenia 63.1 Portugal 36.2 US 13.8 Spain 29.5 EU-25 10.7 Japan 13.5 54
  55. 55. ECON339 / EURO339Is Europe an OCA: a complication….. Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate 55
  56. 56. ECON339 / EURO339Inside the OCA Index: politicalcriteria  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 56
  57. 57. ECON339 / EURO339Commonality of destiny: poll results EU25 SI SK HU IT ES Do you support European EL BE PL political union? CZ DE CY LU (Eurobarometer, 2005) LV PT MT LT EE FR NL IE DK SE AT FI UK 0% 20% 40% 60% 80% 100% For Against Dont know 57
  58. 58. ECON339 / EURO339Overall? The OCA glass is half full, or half empty 58
  59. 59. ECON339 / EURO339History never ends: the endogeneityof 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? 59
  60. 60. ECON339 / EURO339Endogeneity: 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 60
  61. 61. ECON339 / EURO339Endogeneity: will diversificationgrow or decline?  Argument 1: intra-industry trade will grow  Argument 2: specialisation will increase  No firm conclusion so far 61
  62. 62. ECON339 / EURO339Endogeneity: will economies becomemore 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) 62
  63. 63. ECON339 / EURO339Endogeneity: are the political criteriaendogenous?  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 63
  64. 64. ECON339 / EURO339Conclusions 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 64

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