Chapter 3: The Benefits of a Common Currency

1. Chapter 3:The Benefits of a Common Currency De Grauwe: Economics of Monetary Union

2. Introduction • The costs of EMU have mostly to do with macroeconomic management • The benefits are mostly microeconomic in nature • i.e. they arise from efficiency gains of a monetary union

3. Sources of benefits • Less transactions costs • Price transparency • Less uncertainty • Benefits of an international currency • Does monetary union lead to more economic growth?

4. Less transactions costs • Elimination of foreign exchange markets within union eliminates cost of exchanging one currency into another • Cost reductions amount to 0.25 to 0.5% of GDP (according to European Commission) • Full cost reduction only achieved when payments systems are fully integrated • TARGET payment system • New initiatives to create a Single Euro Payments Area (SEPA)

5. Price transparency • One common unit of account facilitates price comparisons • Consumers “shop around” more • Competition increases • Prices decline and consumers gain

6. Will euro increase price transparency in a significant way? • Large price differentials continue to exist • These have to do with • transactions costs at the retail level • and product differentiation • See next tables

9. Eurozone has not increased price convergence Figure 3.1: Evolution of price dispersion in the Eurozone, 1990–2005 • Euro has not changed this • There is no evidence of price convergence • Euro may work indirectly by triggering further market integration in particular sectors, e.g. banking, insurance Source:Wolszczak-Derlacz (2006)

10. The introduction of the Euro and perceived price increases • A major surprise about the introduction of the Euro is its unpopularity in a number of Southern countries • Especially in Italy, but also in Greece, the introduction of the Euro is associated with massive price increases

11. Possible explanation: • Low budget items, with low price elasticities • Competitive markets make it difficult to raise prices • Introduction of Euro creates signal lowering the cost of collective action

12. Less exchange risk • Euro eliminates exchange risk. Two issues: • Does the decline in exchange risk increase welfare? • Does the decline in exchange risk reduce systemic risk?

13. Less exchange risk and welfare • Take individual firm under perfect competition Price certainty Price uncertainty P P MC MC F E P3 G B P1 P1 P2 C q q

14. Profits are higher on average when there is price uncertainty • Welfare will then depend on degree of risk aversion • If risk aversion sufficiently high price certainty is preferred by firms • Model has a number of important assumptions: • No adjustment costs • With sufficiently large price declines firms can go bankrupt; model assumes no bankruptcy costs

15. Exchange rate uncertainty and the price mechanism • Large exchange variability reduces the quality of price signals in allocating resources • Example: large overvaluation of dollar in 1980s led to decline of export sector; a decline that turned out to be unnecessary once the dollar declined again • These large real exchange rate cycles lead to large adjustment costs

16. Monetary Union and economic growth • Neo-classical growth model y r f(k) A r k

17. Potential growth effects of monetary union • MU eliminates exchange risk and may reduce systemic risk. If so, real interest rate declines • rr-line becomes flatter (r’r’) • Economy moves from A to B • Per capita income increases because of capital accumulation • Economic growth increases during transition from A to B y r r’ B f(k) A r’ r k

18. Endogenous growth and monetary union y C f’(k) • Capital accumulation can lead to dynamic effects leading to technological innovations. • Production function f(k) then shifts outwards raising economic growth B f(k) A k

19. Empirical evidence about monetary union and growth • First generation empirical studies found little relation between exchange rate volatility, trade and investment • Using cross-section evidence Andy Rose recently found strong effect of monetary union on trade: • A monetary union doubles trade among members of union, on average • More recent econometric evidence has reduced these effects to 10%-20% • The link monetary union-trade then has positive effect on per capita income (Frankel and Rose)

20. Benefits of an international currency • International use of the dollar creates seigniorage gains for the US • Similarly, if Euro becomes an international currency, seigniorage gains will follow for Euroland • These gains, however, remain relatively small: • in the case of the US: less than 0.5% of GDP per year

21. Benefits of monetary union and openness Benefits (% of GDP) • Benefits of monetary union are likely to be larger for relatively open economies • In absence of monetary union, transactions costs and exchange risk are larger for firms in very open economies • Monetary union will be more beneficial for firms in very open economies • Upward sloping benefit line Trade (% of GDP)

22. Box 5: Fixing exchange rate and systemic risks Shocks in IS-curve: Monetary union increases variability of output r LM F rf ISU IS ISL yL y’L y’U yU y

23. Shocks in LM-curve Monetary union reduces variability of output LML r LM LMU G rf ISU IS ISL yL y yU y