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Theorie und Politik der Europäischen Integration

Theorie und Politik der Europäischen Integration . Theory and Politics of European Integration . Lecture 7 Optimal Currency Area Theory and the EURO Fiscal Policy and the Growth and Stability Pact. Prof. Dr. Herbert Brücker. Last Lecture. Labour market integration Institutions

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Theorie und Politik der Europäischen Integration

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  1. Theorie und Politik der Europäischen Integration • Theory and Politics of European Integration Lecture 7 Optimal Currency Area Theory and the EURO Fiscal Policy and the Growth and Stability Pact • Prof. Dr. Herbert Brücker

  2. Last Lecture Theory and Politics of European Integration A Monetary History of Europe • Labour market integration • Institutions • Scale of migration and income differences • Composition of migrants, self-selection and out-selection • Labour market impact • Standard model with perfect labour markets • Equalisation of wage rates • Aggregate gains, but winners and losers • More complex models: • Capital stock adjustment • Wage rigidities and unemployment • Simulation of labour market effects by skills

  3. This Lecture Theory and Politics of European Integration Fiscal Policy and Stability Pact • An Introduction to Open Economies Macroeconomics • The long-term neutrality of money: theory • The short-term non-neutrality of money • The IS-LM diagram • Exchange rate and fiscal policies and exchange rate regimes Optimum Currency Area (OCA) Theory • Whatarethe trade-offs? • Asymmetricshocksandcurrencyareas • Criteriafor an optimal currencyarea

  4. This Lecture Theory and Politics of European Integration Fiscal Policy and Stability Pact The European Monetary Union (EMU) • Maastricht Treaty and History • The Eurosystem • Objectives, instruments and strategy • The record during the first years • Fiscal Policy and the Stability Pact • Fiscal policy in the monetary union • Borrowing instead of transfers • Automatic stabilizers and discretionary policy actions • Fiscal policy externalities • Spillovers and coordination • Excessive deficit and no-bailout clause • Collective discipline

  5. Reading Theory and Politics of European Integration Fiscal Policy and Stability Pact • Richard Baldwin/Charles Wyplosz, The Economics of European Integration, 3rd Edition, 2009, Ch. 11 (Optimum Currency Areas) and Ch. 18 (Fiscal and Stability Pact)

  6. An Introduction to Open Economy Macroeconomics:Three basic principles Theory and Politics of European Integration A Monetary History of Europe • 1 Long term: neutrality of money and PPP • 2 Short term: non-neutrality of money, real and monetary matters interfere (cyclical fluctuations and shocks) • 3 Interest parity condition

  7. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe • short-term AS • long-term AS • inflationrate • AD • AD • output gap • 0 • The AS-AD model output gap (Actual – Trend GDP)

  8. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe • short-term AS • long-term AS • inflationrate • AD • AD • Aggregate Demand (AD): Why downward sloping? • Inflation erodes purchasing power of money and discourages consumption (and investment). Hence, aggregate demand is higher the lower inflation. • C • B • A • output gap • 0 • The AS-AD model output gap (Actual – Trend GDP)

  9. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe • short-term AS • long-term AS • Inflationrate • AD • AD • AS: Why upward sloping? • Depression results in lower wages and lower prices of firm, while boom results in higher wage and price pressures • output gap • 0 • The AS-AD model output gap (Actual – Trend GDP)

  10. The long-term neutrality of money: theory Theory and Politics of European Integration A Monetary History of Europe • short-term AS • long-term AS • Inflationrate • AD • AD • Long-run: • If prices rise faster than wages, purchasing power declines, creates wage pressure, eventually we move back to long-run wage-price relation at C. • C • B • A • output gap • 0 • The AS-AD model output gap (Actual – Trend GDP)

  11. Long-term neutrality implication: PPP Theory and Politics of European Integration A Monetary History of Europe • The real exchange rate • Defined as  = EP/P* • E = nominal exchange rate; P = domestic price; P* = foreign price • Purchasing Power Parity (PPP): E offsets changes in P/P* • So  is constant • Many caveats, though: • PPP seems to hold in the long run, but not in the short and medium run

  12. Short-term non-neutrality of money Theory and Politics of European Integration A Monetary History of Europe • From AD-AS: the short-run AS schedule • So monetary policy matters in the short run • Channels of monetary policy • The interest rate channel • The credit channel • The stock market channel • The exchange rate channel

  13. Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • foreignlevel • A • D • IS‘ • C • B • IS • Output-gap(Actual-Trend GDP)

  14. Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • IS = Investment-Saving Curve (real sector) • LM = Liquidity Preference-Money Supply Curve (monetary sector) • interest rate • LM • LM‘ • Foreignlevel • A • D • IS‘ • C • B • IS • Outputgap(Actual-Trend GDP)

  15. Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • 1. increase in money supply moves LM to LM‘, • 2. interst rates declines initially to B, • 3. spending expands and economy moves to C • 4. capital flows out until interest rate is back to international level • 5. Different implications under flexibel and fixed exchange rates • Foreignlevel • A • D • IS‘ • C • B • IS • Outputgap(Actual-Trend GDP)

  16. Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • Flexible exchange rate: • currency depreciates • current account improves (IS shifts to IS‘) • output moves eventually to D • Foreignlevel • A • D • IS‘ • C • B • IS • Output-gap(Actual-Trend GDP)

  17. Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • Fixed exchange rate: • Central Bank must intervene in exchange market • money supply shrinks until LM curve shifts back from LM‘ to LM and output to A • Foreignlevel • A • D • IS‘ • C • B • IS • output-gap(Actual-Trend GDP)

  18. Monetary policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • Thus, there is no room for monetary policy with a fixed exchange rate – but with a flexibel one! • Foreignlevel • A • D • IS‘ • C • B • IS • output-gap(Actual-Trend GDP)

  19. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • B • Foreignlevel • A • C • IS‘ • IS • Output-gap(Actual-Trend GDP)

  20. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • B • Foreignlevel • A • C • IS‘ • Fiscal policy shifts IS curve to IS’. • LM stays where it is. • Output moves to B. • The interest rate rises above foreign level. • Capital flows in to restore interest parity • IS • Output-gap(Actual-Trend GDP)

  21. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • B • Foreignlevel • A • C • IS‘ • Fixed exchange rate: • Central Bank intervenes to prevent currency appreciation • sells money such that increased money supply shifts LM to LM’ • economy moves eventually to point C • IS • Output-gap(Actual-Trend GDP)

  22. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • B • Foreignlevel • A • C • IS‘ • IS • Flexible exchange rate: • Capital flows in and currency appreciates • Current account worsens • Demand declines • Eventually, IS’ shifts back to IS and the economy back to A • Output-gap(Actual-Trend GDP)

  23. Fiscal policy in the IS-LM model Theory and Politics of European Integration A Monetary History of Europe • interest rate • LM • LM‘ • Thus, fiscal policy does only work under fixed exchange rates in small open economies! • B • Foreignlevel • A • C • IS‘ • IS • Output-gap(Actual-Trend GDP)

  24. Exchange rate regimes and policy effectiveness Theory and Politics of European Integration A Monetary History of Europe

  25. When does the regime matter? Theory and Politics of European Integration A Monetary History of Europe • In the short run, changes in E are mirrored in changes in  = EP/P*: P and P* are sticky • In the long run,  is independent of E: P adjusts • If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy • Put differently, the choice of an exchange rate regime has mostly short run effects because prices and wages are sticky

  26. A good question, no simple answer Should curreny area borders coincide with national borders? If not, how best to delineate currency areas? What economic criteria should be used? Theory and Politics of European Integration Optimal Currency Areas

  27. The economic toolkit There must be benefits and costs involved in adopting a common currency The solution has to involve trading off these benefits Theory and Politics of European Integration Optimal Currency Areas

  28. In a nutshell The benefits Money exhibitsincreasingreturns to scale(network externalities) E.g. yousave transaction costs for money exchange the people use yourcurrency The world is the way to maximizethesebenefits The costs Loss of monetary and exchange rate instruments Matters in presence of: Price and wagestickiness Asymmetricshocks Theory and Politics of European Integration Optimal Currency Areas

  29. Focusing on costs Start with the idea that benefits argue for one worldwide currency Ask why not Look at the costs No precise way of estimating costs and benefits so, in the end, a matter of judgement Look at asymmetric costs How they create trouble What makes them more likely What makes them less painful Theory and Politics of European Integration Optimal Currency Areas

  30. Asymmetric shocks Simplestexample: an adverse demandshock: how can the exchange rate help? Assumption: stickyprices and wages Definition of exchange rate: EP/P* or in terms of wages: E W/W* Theory and Politics of European Integration Optimal Currency Areas

  31. Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help? Theory and Politics of European Integration Optimal Currency Areas • If domestic prices and wages are sticky, adverse demand shock will reduce production to C if exchange rate does not adjust

  32. Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help? Theory and Politics of European Integration Optimal Currency Areas • If exchange rate adjusts, production declines to D.

  33. Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas

  34. Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas No currency union case:Real exchange rate declines in country A to λ1, productiondeclinesto B, country B remainsunaffected. Whatwould happen ifexchange rate staysatλ0?

  35. Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas No currency union case:Real exchange rate declines in country A to λ1, productiondeclinesto B, country B remainsunaffected. Whatwould happen ifexchange rate staysatλ0?

  36. Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas Currency union case:Central Bank let currency decline to λ2. Productiondeclines in country A to C, in country B to D, andexcessdemandcreatesinflationarypressure D-D‘.

  37. Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas • Disequilbria don‘t last forever. In country A wages and prices decline, such that production moves to equilibrium point B. In country B wages and prices will increase, until economy is back to point A as well.

  38. Implications of asymmetric shocks Thus, both countries are hurt when they share the same currency Also the case when a symmetric shock creates asymmetric effects This is an unavoidable cost of a currency area Theory and Politics of European Integration Optimal Currency Areas

  39. Six critieria for an optimal currency area Next questions: What reduces the incidence of asymmetric shocks? What makes it easier to cope with shocks when they occur The analysis develops six criteria for an optimal currency area (OCA) Three economic labour mobility diversion trade openness Three political transfers homogeneous preferences Common destiny Theory and Politics of European Integration Optimal Currency Areas

  40. Criterion 1 (Mundell): Labour mobility In an OCA labour moves easily across national borders. Caveats Labour mobility is easy within national borders (culture, language, legislation, welfare, etc…), but much less so across national borders Capital mobility: difference between financial and physical capital In case of country specialization, skills also matter and hinder labour mobility Theory and Politics of European Integration Optimal Currency Areas

  41. Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas • What happens with labour mobility? • Assume exchange rate declines to λ2 and production is at C‘ in country 1 and D in country 2.

  42. Asymmetric shocks: adverse demand shock in 2 country CU • Labour mobility shifts supply curve leftwards in Country A to S‘ and rightswards in Country B to S‘. • New equilibrium for production is at C and D‘. • Output gap is zero. Theory and Politics of European Integration Optimal Currency Areas

  43. Criterion 2 (Kenen): Production diversification Countries whose production and exports are widely diversified and of similar structure form an OCA. Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern Theory and Politics of European Integration Optimal Currency Areas

  44. Criterion 3 (McKinnon): 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 Theory and Politics of European Integration Optimal Currency Areas

  45. Criterion 4: Fiscal transfers Countries that agree to compensate each other for adverse shock 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 (e.g. unemployment benefits) Explicitly in federal states Theory and Politics of European Integration Optimal Currency Areas

  46. 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 criterion is satisfied Do countries agree how to adress symmetric shocks? Should we favour exporters (currency depreciation) or consumers (currency appreciation)? How much? May also help for asymmetric shocks Better understanding of partners’ actions Encourages transfers Theory and Politics of European Integration Optimal Currency Areas

  47. Criterion 6: Commonality of destiny 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 Solidarity vs. Nationalism Theory and Politics of European Integration Optimal Currency Areas

  48. Is Europe an OCA? A synthetic OCA index: How much of a currency appreciation/devaluation vis-à-vis the DM is needed to keep economic conditions unchanged? A ten year period is considered. Indicator for the relevance of adjustment pressures from asymmetric shocks. Theory and Politics of European Integration Optimal Currency Areas

  49. Inside the OCA index: Openness Most EU countries are very open: The McKinnon criterion is broadly satisfied Theory and Politics of European Integration Optimal Currency Areas

  50. Inside the OCA index: Diversification 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 Theory and Politics of European Integration Optimal Currency Areas

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