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Monetary integration
José Villaverde CastroUniversidad de Cantabria
This slides are based on the book “Economics of Monetary Union”, by P. De Grauwe. OUP.
Outline of the presentation
–Degrees of economic integration–Concept of a monetary union–The costs of a monetary union–The benefits of a monetary union–Costs and benefits compared
Degrees of economic integration
No visible trade restrictions
Common external trade restrictions
No invisible trade restrictions
Free mobility of factors and assets
Common currency
Common economic policy
Free trade area X
Custom union X XInternal commodity market X X X
Common market X X X X
Monetary union X X X X X
Economic union X X X X X X
– Common currency– Common central bank
Concept of a monetary union
The costs of a common currency
• Costs arise because, when joining a monetary union, a country looses policy instrument: monetary policy (e.g. exchange rate, interest rate)
• This is costly when asymmetric shocks occur
• Sources of asymmetry: – Shifts in demand– Different preferences between inflation and
unemployment
Shifts in demand (Mundell)
• Assume two countries, France and Germany
• Asymmetric shock in demand– Need to distinguish between permanent and
temporary shock– Decline in aggregate demand in France– Increase in aggregate demand in Germany
• We will analyze this shock in two regimes– Monetary union– Monetary independence
PF PG
YF YG
France Germany
Aggregate demand and supply in France and Germany
DFDG
SF
SG
• How can France and Germany deal with this shock if they form a monetary union?
• Thus France cannot stimulate demand using monetary policy; nor can Germany restrict aggregate demand using monetary policy
• Do there exist alternative adjustment mechanisms in monetary union?– Wage flexibility– Labour mobility
First regime: monetary union
PF PG
YF YG
France Germany
The automatic adjustment process (Wage flexibility)
PF PG
YF YG
France Germany
Second regime: Monetary independence
DFDG
SF
SG
• Thus, when asymmetric shocks occur• And when there are a lot of rigidities• Monetary union may be more costly
than monetary independence• What about fiscal policies? (income
transfers between countries or between generations)
Conclusion
Fiscal policy
Automatic stabilisers: Centralised budget or decentralised budget
•Centralised budget allows for automatic transfers between countries of the monetary union•Decentralised: flexible national budgets
– France allows deficit to accumulate; Germany allows surplus
– This imples automatic transfers between generations within the same countries
– Create problems of debt accumulation and sustainability
Other sources of asymmetry (In the response to shocks)
• Different labour market institutions (supply shocks): Centralized versus non-centralized wage bargaining.
• Different financial systems• Different growth rates• Different fiscal systems: Goverment budget
constraint: (G-T-rB= dB/dt + dM/dt)
PF PG
YF YG
France Germany
Symetric shocks in a monetary union
The benefits of a common currency
•The costs of EMU have mostly to do with macroeconomic management•The benefits are mostly microeconomic in nature: they arise from efficiency gains
Sources of benefits
• Less transactions costs: Direct and Indirect effects (Price transparency)
• Less uncertainty: No exchange rate risk
• Benefits of an international currency• Does monetary union lead to more
economic growth?
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)
Price transparency
• One common unit of account facilitates price comparisons: Consumers “shop around” more.
• Competition increases.• Prices decline and consumers gain.
Less exchange risk
• Euro eliminates exchange risk. Less uncertainty. Increase welfare– Does the decline in exchange risk
increase welfare?
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
Benefits of monetary union and openness
Benefits(% of GDP)
Trade (% 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
The cost of a monetary union and the openness of a country
Cost(% of GDP)
Trade (% 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 instument of policy that is relatively ineffective, and are more resilient
Costs and benefits of a monetary union
Benefits
CostsCo
sts
and
Ben
efit
s (%
GD
P)
Trade (% GDP)
Two views about costs and benefits of MU
Trade (% GDP) Trade (%GDP)
Cos
ts a
nd b
enef
its
Cos
ts a
nd b
enef
its
Benefits
Costs
Costs
Benefits
T* T*
(a) The monetarist view (b) The Keynesian view
Two views about costs of MU
• The 'monetarist‘ view : – Monetary policies are ineffective as
instruments to correct for different developments between countries.
– The cost curve is close to the origin. – Thus, many countries in the world
would gain by relinquishing their national currencies, and by joining a monetary union.
• The 'Keynesian' view :– the world is full of rigidities– Monetary policy (including exchange
rate policy) is a powerful instrument in eliminating disequilibria
– the cost curve is far away from the origin
– relatively few countries should find it in their interest to join a monetary union
Costs and benefits with decreasing rigidities
Cos
ts a
nd b
enef
its
Trade (% GDP)
T* T**
Benefits
Costs
With decline in wage and price rigidities and an increase in labour mobility:
Cost curve shifts downwards
Monetary union becomes more attractive