Chapter 2 The Theory of Optimum Currency Areas: A Critique

Chapter 2 The Theory of Optimum Currency Areas: A Critique

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? Lets 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 % ) Germany 7 Eurozone US 6 UK percent increase 5 4

3 2 1 0 2000 2001 2002 2003 2004 2005 2006

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

Real effective exchange rates (ULC) within Eurozone 120 115 BLEU 110 Germany Greece ULC 105 Spain France 100

Ireland Italy 95 Netherl Austria 90 Portugal Finland 85 80 1998 1999

2000 2001 2002 2003 2004 2005 2006 Index is based on ULC (takes into account productivity

differentials) Germany improves its competitive position At the expense of many other Eurozone countries 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 SF(W2) SF(W1) F F DF DF YF 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 P Y 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 Figure 1.1: Aggregate demand and supply in France and Germany France PF Germany P SF G DF

YF SG DG YG 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 wG .

qG . pG 0 UG . Italy wI . qI

. pI 0 UI An aside: Productivity and inflation in monetary union The Balassa-Samuelson effect Inflation differentials in monetary union can be significant 4,0 3,5 Inflation (%) 3,0 2,5

2,0 1,5 1,0 0,5 0,0 FIN GER AUT FR BEL EU12 IT NL LUX PT SP GRE IRL Average yearly inflation in Eurozone countries, 1999-2005 (%) Balassa-Samuelson model

. . . p c F p F (1 ) w F Inflation in France . . . p c I p I (1 ) w I Inflation in Ireland (we assume that inflation in non-tradables is equal to wage inflation) Inflation rates in tradable goods sectors are equal

. . pF p I . . . . This leads to p c F pc I (1 )(w F w I ) Assuming that differences in wage increases reflect differences . . in productivity .

. growth we obtain p c F pc I (1 )(q F q I ) Inflation in Ireland exceeds inflation in France if Irish productivity increases faster than French productivity Should wage bargaining be centralized in monetary union? w F w I q F q I 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

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 Figure 2.9: The Phillips curve and natural unemployment There is a short-term tradeoff 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.eall points for which p p This vertical line defines the natural rate of unemployment UN . p . p2

. . e . p p2 p1 . p UN .

e . p1 p e 0 U Figure 2.12: The preferences of the authorities p I3 I2 I1 Indifference curves are concave Slope expresses

relative importance attached to fighting inflation versus fighting unemployment U Figure 2.13: The preferences of the authorities p Hard-nosed government Wet government p I3 I2

I3 I1 I2 I1 Hard-nosed government U attaches a lot of weight to fighting inflation Wet government attaches U a lot of weight to fighting unemployment Figure 2.14: The equilibrium inflation rate p

E C p 1 p e p 1 B A UN p e 0 U 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 Hard-nosed government

p Wet government p E E B B A A UN

U UN U 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 Equilibrium inflation rate also depends on the level of the natural unemployment E

E B A UN UN U 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. e p I p G

How can Italy reach a more attractive (lower) inflation equilibrium? Germany Italy p G p I E G p G C

F A UG UI 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 Figure 2.18: Optimal stabilization in country with high preference for unemployment stability Dotted line is optimal B stabilisation line Without stabilisation A B C unemployment would increase

U to B after shock U With stabilisation increase in unemployment is limited to B The price paid is higher inflation UL Price increases with steepness of stabilisation line 1 U UN U1

U2 Figure 2.19: Optimal stabilization in country with low preference for unemployment stability This country cares less about unemployment Same shock will lead to stronger increase in unemployment But less inflation B 2 C A

B UU U UN U1 U2 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 Figure 2.20: Effectiveness of currency depreciation as a function of openness PO Very open country PC Relatively closed country SO SC DO

YO DC YC Figure 2.21: The cost of a monetary union and the openness of a country Cost (% 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 Trade (% of GDP

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