2. The Euro Zone as an Optimum Currency Area

1. 2. The Euro Zone as an Optimum Currency Area Costs and Benefits of a Monetary Union

2. OCA Theory: Definition and Evolution • Pioneered by Mundell (1961), McKinnon (1963) and Kenen (1969) • First stream (60s-70s) focussed on the cost side of the cost-benefit analysis of a monetary union (MU) • Objective: to identify crucial economic characteristics required for a country to be an optimal member of a MU • Second stream (70s-till now) focussed on the analysis of costs and benefits for countries intending to participate in a MU • More recent evolution: the endogeneity of the OCA criteria (Frankel & Rose, 1996)

3. 2.1. The Benefits of Joining a Monetary Union (MU) • Elimination of transaction costs • Direct gains from elimination of costs to exchange currencies (EC estimates between 13 and 20 billion euro per year) • Indirect gains from price transparency (but see Table 3.1)

4. 2.1. The Benefits of Joining a Monetary Union (MU) • Less uncertainty due to elimination of exchange rate risk (reducing uncertainty in the price system and negative consequences on the allocation of resources) • Less uncertainty increases trade between countries. A. Rose (2000) found that trade flows between countries which form a MU are on average 100 % higher. • Beneficial impact of less uncertainty on growth (reduction of real interest rate, temporary increase in the growth rate, higher output level per capita in equilibrium). • Moreover, Frankel and Rose (2002) found that 1 per cent increas in trade leads to increase of per capita GDP of one third of a percantage point.

6. 2.2. The Costs of Joining a MU? • Joining a MU means relinquishing an instrument of economic policy (no independent monetary policy) • Use of the exchange rate as a policy instrument is not possible any more • Structural differences between countries could make it costly to give up this instrument • We now examine: (1) Mundell’s model of a demand shift; (2) insurance mechanisms against asymmetric shocks; (3) differences in labour market institutions

7. (1) Mundell’s model: a brief description • 2 countries (France and Germany) form a MU • Starting point: asymmetric shock in aggregate demand (change in consumers’ preferences) • Upward movement of demand curve in DE and downward movement of demand curve in FR • Result: output declines and unemployment increases in FR and opposite happens in DE • Crucial question: are there mechanisms leading automatically back to equilibrium?

8. A graphical representation

9. The adjustment mechanisms • Automatic adjustment through wage flexibility: wages decrease in FR and increase in DE (shifting the supply curves) (and causing second-order effects of wage and price changes on aggregate demand) • Automatic adjustment through labour mobility: unemployed workers move from FR to DE (removing pressures on labour markets: no change in wages) • If downward rigidity of wage in FR and no movement of labour: adjustment occurs through inflation in DE, making French goods more competitive • Adjustment through devaluation/revaluation in case FR and DE are not in MU (shift in demand curves back to initial position)

10. A graphical representation

11. Conclusions • Harder to adjust to asymmetric demand shocks for countries in a MU in case of wage rigidity and limited labour mobility • The exchange rate could add flexibility in this overly rigid system

12. 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.

13. McKinnon: Openness • Countries which are very open to trade and trade heavily with each other form an OCA. • Distinguish between traded and nontraded 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.

14. Insurance against asymmetric shocks in a MU • Mechanisms for income transfers between countries in a MU make asymmetric shocks less painful (reducing the cost of the MU) • Should not prevent adjustment through wage flexibility and labour mobility, especially in case of permanent asymmetric shocks (issue of sustainability of permanent transfers)

15. Public insurance schemes • 1st option: public insurance system through a centralized federal budget (adjustment eased through taxes and transfers) • Not present in the EU (budget is 1.4% of EU GDP). See Table B1.1 for an example in Germany • 2nd option: national budgets for countries in MU and adjustment through national government budget deficits and government debt (issue of sustainability of public debt) • In 1st option inter-regional transfers; in 2nd option inter-generational transfers

17. Conclusions • Asymmetric shocks in a MU require wage flexibility and labour mobility • Insurance mechanisms help but cannot substitute the adjustment process (esp. for permanent shocks)

18. Differences in labour market institutions • A different degree of centralization of wage bargaining across countries in a MU can lead to divergent wage and price developments • Popular analysis by Bruno and Sachs (1985) • Idea: centralization of wage bargaining gives no incentive to excessive wage claims (inflationary effects of wage increases are internalized)

19. Bruno & Sachs more in detail • In case of supply shock and centralized wage bargaining the trade unions realize that the loss in real wage cannot be compensated by nominal wage increases (leading to more inflation) • In case of supply shock and less centralized wage bargaining each union (representing small fraction of labour force) has incentive to increase the nominal wage of its members (free-riding) • Result: decentralized system (non-cooperative game) leading to higher nominal wage level than the centralized system (cooperative game)

20. Conclusions • The degree of centralization of wage bargaining affects the evolution of wages and prices • Even in presence of the same supply shock different countries can display a different impact on the price level • Costs of a MU tend to be higher for countries with very different labour market institutions

21. 2.2.4. OCA Theory: a Critical Approach Three crucial questions: • 1. Are the mentioned differences between countries really important? • 2. Is the exchange rate really effective in correcting for these differences? • 3. Is the exchange rate a “dangerous” policy instrument in the hands of the politicians?

22. 2.2.4. OCA Theory: a Critical Approach Three crucial questions: • 1. Are the mentioned differences between countries really important? • 2. Is the exchange rate really effective in correcting for these differences? • 3. Is the exchange rate a “dangerous” policy instrument in the hands of the politicians?

23. Likelihood of asymmetric demand shocks in a MU • Two different views: the European Commission view and Krugman view • EC view: asymmetric shocks will occur less frequently in a MU (integration leads to more IIT, thus more symmetric effects of demand shocks) • Krugman view: asymmetric shocks will become more frequent in a MU (integration leads to more regional concentration of industrial activities, thus sector-specific shocks tend to become country-specific shocks)

24. EC’s view versus the Krugman’s view EC’s View Krugman’s View

25. (Tentative) Conclusions • Results are thus controversial • Presumption in favour of EC: national borders less and less important for industrial clustering in a more integrated context (specialization at level of regions encompassing national borders) • Implication: regional asymmetric shocks rather than national asymmetric shocks • Exchange rates between national currencies unable to cope with these kinds of shocks (reduction in the costs of giving up this instrument)

26. Institutional differences in labour markets • Crucial question: are these differences bound to disappear in a MU? • We can expect less pronounced differences in unions’ behaviour across countries in MU (unions are aware that there is less margin left for accommodating national policies) • But we can expect also these differences to persist for quite some time after the creation of a MU • This may lead to adjustment problems in the MU given the exchange rate has disappeared

27. 2.2.4. OCA Theory: a Critical Approach Three crucial questions: • 1. Are the mentioned differences between countries really important? • 2. Is the exchange rate really effective in correcting for these differences? • 3. Is the exchange rate a “dangerous” policy instrument in the hands of the politicians?

28. Devaluations as a response to asymmetric demand shocks • Mundell’s model: devaluation makes aggregate demand shift upwards • However: initial favourable effects of devaluation tend to disappear over time

29. Conclusions • Giving up the exchange rate as a policy instrument implies no cost in terms of long-run analysis (the exchange rate is not effective) • There is a cost in terms of short-run analysis, given the different dynamics of the alternative policy (expenditure-reducing policy)

30. 2.3. Comparision between Costs and Benefits (I) • Relationship between costs and benefits of the MU and the openness of a country:

31. 2.3. Comparision between Costs and Benefits (II) • Gains likely to increase with the degree of openness (larger benefits from elimination of transact. costs and exchange rate risk) • Costs likely to decrease with the degree of openness (less frequent asymmetric shocks + larger negative impact of devaluation on price level)

32. The endogeneity of the OCA criteria (Frankel & Rose, 1996) • Endogenous component: after countries decide to form a MU they tend to score better in terms of OCA criteria • Thus, OCA criteria may be satisfied ex post, even if they are not satisfied ex ante • For instance, entry into the MU may raise trade linkages and business cycles across countries may become more similar • Application of the ‘Lucas Critique’ (suitability of countries for a MU cannot be judged based on historical data, since economic structures likely to change in the event of MU)

33. Cost – Benefit Analysis: Conclusions

34. Bibliographic references • Main reference: • De Grauwe, P. (2006), Economics of Monetary Union (Ch. 1-4) • Secondary reference: • Zestos, G.K. (2006) European monetary Integration, (Ch. 2)