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The optimum currency area theory

The optimum currency area theory. Lecture outline. The Mundell, McKinnon and Kenen models The „new” OCA theory The comparative approach The endogeneity of OCA. The Mundell model. Assumptions two countries full employment BP in equilibrium short term price and wage rigidity.

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The optimum currency area theory

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  1. The optimum currency area theory International finance 120181-1165

  2. Lecture outline • The Mundell, McKinnon and Kenen models • The „new” OCA theory • The comparative approach • The endogeneity of OCA International finance 120181-1165

  3. The Mundell model • Assumptions • two countries • full employment • BP in equilibrium • short term price and wage rigidity International finance 120181-1165

  4. The Mundell model • Demand shock analysis • Two cases: • different currencies in two countries • currency union International finance 120181-1165

  5. The Mundell model • Demand increases for country A products • Demand decreases for country B products • Inflationary pressures in country A, unemployment growth in country B • If countries use separate currencies ER adjustments International finance 120181-1165

  6. The Mundell model • In case of a currency union: • Expansionary monetary policy in country B causes inflationary pressures in country A • Worsening of terms of trade in country A versus country B • The need to adjust demand shocks by other means than ER- labour force mobility International finance 120181-1165

  7. The Mundell model Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000 International finance 120181-1165

  8. Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000 The Mundell model International finance 120181-1165

  9. Modifying assumptions • Modifying the assumption of price and wage rigidity  new adjustment instruments • Labour market flexibility International finance 120181-1165

  10. Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000 Adjustment through prices and wages changes International finance 120181-1165

  11. Conlusions from the Mundell model • If two economies characterized by price and wage rigidity want to introduce a currency union they should ensure labour force mobility International finance 120181-1165

  12. The McKinnon model • The comparison of the utility of two instruments reinstating the external equilibrium depending on the openness of the economy : • Flexible ER • Internal monetary and fiscal policy • The openness of the economy – the ratio of tradable and nontradable products in the production and consumption structure International finance 120181-1165

  13. The McKinnon model • Assumptions: • Two economies - different openness • No factor mobility International finance 120181-1165

  14. The McKinnon model • An open economy • Flexible ER as a mean of maintaining the external equilibrium • Growing demand for tradables  current account deficit International finance 120181-1165

  15. The McKinnon model • Devaluation  price increase of the imported goods vs. nontradables  supply growth of tradables and demand growth for nontradables  BP equilibrium reinstated but • the tradables price increase is permanent International finance 120181-1165

  16. The McKinnon model • External equilibrium reinstatement by contractionary fiscal policy • Influence on employment??? • The effect of BP improvement outperforms the effect of employment reduction depending on the grade of openness International finance 120181-1165

  17. The McKinnon model • A less open economy • Demand grows for tradables  current account deficit • Devaluation  price increase of the imported goods vs. nontradables  supply growth of tradables and demand growth for nontradables  BP equilibrium reinstated International finance 120181-1165

  18. The McKinnon model • Contractionary fiscal policy  the influence mostly on the nontradables sector • High share of nontradables  unemployment increase International finance 120181-1165

  19. The McKinnon model Source: Own elaboration based on: K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006 International finance 120181-1165

  20. Conclusions from the McKinnon model • The higher the grade of openness of economy the lower is the efficiency of a flexible ER as an adjustment tool and the higher is its negative influence on price stability International finance 120181-1165

  21. The Kenen model • Assumptions: • Two economies with different production structure diversification • Factor mobility • Demand shocks analysis International finance 120181-1165

  22. The Kenen model • Demand shock  internal equilibrium exacerbated • The effect on external balance depends on the grade of diversification • Higher diversification  shocks concern only a part of the production/exports International finance 120181-1165

  23. Conclusions from the Kenen model • Countries can create a currency union provided a diversified export structure is ensured • An economy with higher production diversification does not have to use the ER as adjustment tool as often as a less diversified economy International finance 120181-1165

  24. The optimalisation criteria deriving from the „old” theory • factor mobility • labour market flexibility • the openness of the economy • production diversification International finance 120181-1165

  25. The drawbacks of the „old” theory • Rigid prices assumption • Demand side approach • The only cost of monetary integration is the loss of ER as adjustment instrument • Consideration of the cost of monetary integration, the advantages are neglected International finance 120181-1165

  26. „The „new” OCA theory • Keynesian assumptions rejected • Ingram (1969)- integration of financial markets • Haberler (1970) and Fleming (1971)- inflation rates similarity • Corden (1972) and Giersch (1973)- inflation preferences similarity International finance 120181-1165

  27. Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003, International finance 120181-1165

  28. Opracowanie własne na podstawie P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003, International finance 120181-1165

  29. The Barro-Gordon model • Monetary policy credibility analysis after establishing a monetary union • Rational inflation expectations • U-Un=α(Лe-Л) International finance 120181-1165

  30. The Barro-Gordon model • Different preferences concerning the restrictiveness of the monetary policy • In one of the countries the CB is not credible  the inflation target is not fulfilled • Rational expectations  price increase • Currency union  there is only one common inflation level set by a supranational CB International finance 120181-1165

  31. The Barro-Gordon model • Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003, International finance 120181-1165

  32. Coclusions from the Barro-Gordon model • The establishment of a currency union may influence positively the credibility of the monetary policy of a country, which previously led an inefficient monetary policy • The condition: the supranational CB conducts a monetary policy designed as the policy of the country with the lowest inflation International finance 120181-1165

  33. The advantages of creating a monetary union • Creating a monetary union  monetary credibility increase and the decrease of risk premium+ ER risk elimination • A single decrease of the risk premium contributes to production growth • Learning effects, effects of scale and additional capital accumulation  potential increase of productivity in the long term International finance 120181-1165

  34. The advantages of creating a monetary union Source: Own elaboration based on: de Grauwe, op. cit International finance 120181-1165

  35. The comparative OCA approach • Assessing the gains and losses related to monetary unification • The Keynesian and monetarist approach • The extent of gains and losses depends on the assessment of the ER efficiency as adjustment tool International finance 120181-1165

  36. The comparative OCA approach Source: Own elaboration based on: de Grauwe, op.cit. International finance 120181-1165

  37. The comparative OCA approach • Krugman’s approach vs. European Commission’s approach • The symmetry of shocks as optimalisation criterion • The influence of trade integration on the symmetry of shocks International finance 120181-1165

  38. The endogeneity of OCA • The influence of trade integration on the assymetry of shocks • Countries which do not fulfill the OCA criteria ex ante may fulfill them ex psot • Empirical evidence Bayoumi and Eichengreen (1996), Frankel and Rose (1996) International finance 120181-1165

  39. The endogeneity of OCA • One can not assess the fulfilment of the OCA criteria on the base of historical data • Endogenous processes within currency unions • Positive correlation between trade intensity and business cycle correlation International finance 120181-1165

  40. The endogeneity of OCA Source: Own elaboration based on: F. Mongelli, „New“ views on the optimum currency area theory: what is EMU telling us?, ECB Working Paper no. 138, ECB, Frankfurt am Main 2002, International finance 120181-1165

  41. Summing up • Some of the OCA criteria: • Factor mobility • Labour market flexibility • The openness of the economy • Production diversification • Symmetry of shocks • Financial integration • Similarity of inflation levels International finance 120181-1165

  42. Summing up • „The old” and „the new” OCA theory • The assesmesnt of the ER efficiency as an economic policy tool • The comparative approach- Krugman vs. EC • The endogeneity of OCA International finance 120181-1165

  43. References • A. Alesina, R. Barro, Currency unions, Quarterly journal of Economics, 2002 • T. Bayoumi, The formal model of optimum currency areas, IMF Staff Papers, vol. 41, 1994, • T. Bayoumi, B. Eichengreen, Ever closer to heaven? An optimum currency area index for European countries, European Economic Review no.41, 1997 • J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000 • J. Frankel, A. Rose, The endogeneity of the optimum currency area criteria, NBER Working Paper, Cambridge 1996 International finance 120181-1165

  44. References • P. De Grauwe, Economics of monetary union, Oxford University Press, 2007. • P. Kenen, The theory of optimum currency areas: an eclectic view w: Monetary problems of the international economy, The University of Chicago Press, Chicago & London 1969 • R. McKinnon, Optimum currency areas, The American Economic Review vol. 53, 1963 • R. Mundell, A theory of optimum currency areas, The American Economic Review vol. 51, 1961 • K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006 International finance 120181-1165

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