OPTIMAL OPTIMAL CURRENCY CURRENCY

AREA IAREA IWeek 2Week 2

Chapter 1 and 2.Chapter 1 and 2.

What we have learnt last What we have learnt last weekweek

• Countries use macroeconomic policy (monetary, fiscal, exchange rate) for aggregate demand management in the short-run (to fight downturns or to prevent inflationary pressures)

• to keep aggregate demand in line with potential output growth

• which is ultimately determined by long-run supply-side factors (total factor productivity, labour force growth)• MACROECONOMIC POLICY REACTS TO SHOCKS

Plan of Week 2 and 3Plan of Week 2 and 3• 1) The costs of a monetary union

(Optimal Currency Area theory)

• 2) OCA critiques

• 3) The benefits of a monetary union

THE COSTS OF A MONETARY THE COSTS OF A MONETARY UNIONUNION

• Joining a monetary union implies the lost of two out of three national macroeconomic policies:

• Monetary policy: a common central bank prints the new currency and is in charge of determining the short-term interest rate

• Exchange rate policy: national currencies disappear, so there’s no chance of altering/determining its external value to restore competiveness (depreciation) or to decrease imports price (appreciation)

• When a country joins a monetary union, it looses the ability of determining two of the three prices of money:

• Interest rate• Exchange rate• (it still can affect inflation, by pushing aggregate

demand via fiscal policy)

A country looses two of the three “weapons” against recessions and shocks, and its overall “fighting” ability is severly undermined.

So in order for monetary union to be desirable, countries must have some other mechanism at work to fight recessions and restore macroeconomic equilibrium.

• Optimal Currency Area (OCA)

• (Robert Mundell, 1961)

• It defines the conditions under which it is optimal for a group of countries to form a monetary union

• Optimal…?• There are other forces capable of fighting

asymmetric shocks (events that affect countries in opposite ways)

• A shift in demand from German to French products

• A oli price shock (it helps exportes, it damages importers)

What are those What are those mechanisms/forces?mechanisms/forces?

• Competition forces (free market forces) on prices (a) and quantities (b) of labour:

• a) wages• b) migration of workers

Back to the most important diagram in macroeconomics

Aggregate demand, aggregate supply

Negative shock in France, positive in Negative shock in France, positive in Germany (AD curve shifts)Germany (AD curve shifts)

• a) If wages are flexible, they will decline in France (AS curve shifts rightward) and rise in Germany (AS curve shifts leftward). Macroeconomic equilibrium is restored in both countries.

• b) If there is mobility of labour, unemployed workers will migrate from France to Germany (eliminating the need for wage decline in F and wage increase in G)

• SUPPLY SIDE FORCES (acting through labour market), LED BY FREE MARKET AND COMPETITION, RESTORE MACROECONOMIC EQUILIBRIUM IN BOTH COUNTRIES.

But what would be the easier But what would be the easier solution…?solution…?

• Use macroeconomic policy. • Expansionary in France (decrease interest rate,

devaluate exchange rate)• Contractionary in Germany (increase interest

rate, revaluate exchange rate)• Monetary policy and/or exchange rate policy just

bring back AD curve where it used to be before the (asymmetric shock).

• But if countries are in a monetary union, they just cannot do that.

So……So……• In presence of wage flexibility and mobility of

labour countries have the necessary market-based tools to fight asymmetric shocks, and thus they can afford to give up (most of the) national macroeconomic policies. They form a Optimal Currency Area

• If those adjustment mechanisms are prevented, the cost of joining a monetary union (loosing two of the three macro weapons) are too high and dangerous.

Why should those adjustment mechanism be Why should those adjustment mechanism be prevented?prevented?

• a) Are wages fully flexible? Do they really (and quickly) increase during booms and decrease during downturns? (staggered contracts, trade unions……nominal and real labour market rigidities).

• b) Are workers really perfectly mobile? (languages, cultural barriers, family ties)

What’s the case in Europe?a) Rigidity in the labour (and goods) marketb) 23 different languages and immigration

concerns (the “Polish plummer”)

• When euro was for the first time put forward, a long list of prominent economists predicted failure of the monetary union. Starting from Robert Mundell himself.

• Ten years later (1999-2009) they all had to admit that they were wrong. For basically two reasons:

a) OCA theory itself can be subject to criticisms.

b) There are also benefits from sharing a common currency.

We’ll go through a) next week. Today: - we’ll analyze in greater details the argument for

not-having a single currency - we’ll explore a).

““Countries are different and so they Countries are different and so they cannot wear the same jacket” cannot wear the same jacket”

• Or, better……• Countries differ for many economic and

institutional features.• Thus they cannot share the same interest rate

and the same exchange rate, because it would be as if you tried to have different size people wear the same clothes.

• There is too much heterogeneity in EU national economies.

• Let’s see the main sources of heterogeneity.

1) Different preferences on 1) Different preferences on inflation/unemployment combinationinflation/unemployment combination

• Look at AD curve movement along the AS curve.• More unemployment (=lower GDP growth), less

inflation• Less unemployment (=higher GDP growth), more

inflation.• So there is a negative relationship between

inflation () and unemployment (U):• The Phillips Curve (Phillips, 1958)

unemployment

inflation

• Open-economy equilibrium condition:

• If Italy wants to have an inflation rate higher than Germany’s (or does not manage to reduce it), then it has to depreciate its exchange rate accordingly, to compensate for the reduced competitiviness.

G IE

G IE

• In fact:• If italian inflation is higher: Italy looses

competitiveness (goods and services are more expensive, and thus they loose market shares)

• If exchange rate is lower: Italy gains competitiveness (it takes fewer dollars to buy 1 euro, so the dollar price of a european product is artificially lower)

• “Artificially” because the lower price does not depend on lower production costs, more innovation, better technology, but merely on the lower value of the unit of account.

• If countries do not form a monetary union, then they are free to choose whatever combination they like on the Phillips curve:

• High inflation, lower unemployment (Italy)• Low inflation, higher unemployment (Germany)

Inflation differentials will be offset by exchange rate (consistent with them being different sides of the same coin: prices of money)

In fact, italian lira kept depreciating towards German mark throughout the decades.

• If countries form a monetary union, then inflation differentials cannot be compensated by exchange rate.

• So if Italy does not want to suffer sever market share losses, it has to harmonize its inflation rate with Germany.

• So countries are no longer free to choose the best point on their Phillips curve. That is a cost.

• Anticipation of point 1 critiques: are you sure that countries are permanently free to choose their best combination? To reduce unemployment by suffering a little bit of inflation?

2) Differences in labour market institutions2) Differences in labour market institutions

• Labour markets differ consistently across countries.

• More or less flexibility• More or less centralization• Trade unions role and bargaining process.

• Idea: supply shocks transmission (i.e. oil price increase) varies across countries according to the functioning of labour market institutions

• WAGE CLAIM MODERATION• High degree of centralization in wage bargaining:

unions internalize that excessive nominal wage increase will lead to more inflation, and therefore will not preserve real wage

• Low degree of centralization (wage bargaining at firm level): due to little bargaining power, any excessive wage claim will lead to strong employment reduction

• WAGE CLAIM NON-MODERATION• Any intermediate level of centralization (many

small unions) will create a situation where each union does not internalize the aggregate problem: they think that their own wage increase will have a negligible effect on aggregate wage (and therefore price) level (and they are right!)

• But any other union will act the same way• Standing-up game at the football match• As a result, nominal wage level will increse, AS

curve will shift further leftwards, price level will futher increase.

• Transmission of supply shocks may be very different according to the functioning of labour market.

• Countries with very different labour market institutions might find it costly to form a monetary union: with asymmetric supply shocks, wages and prices are affected differently (and nation-specific policy responses are no longer available) and so OCA-automatic-mechanisms are not uniform.

• EU nations’labour market are indeed very different:

• UK, Denmark: flexibility• Italy, Greece, France: rigidity

3) Differences in legal system and interest 3) Differences in legal system and interest rate transmissionrate transmission

• An 1% increase in interest rate can have different effects on EU national economies, due to:

• a) differences in banking system (degree of competition, regulation, legal framworks)

• b) differences in companies’financing (through capital market or banks)

• Financial market integration is indeed a goal of EU integration process (Week 10)

4) Differences in growth rates4) Differences in growth rates

• I am sorry……

The case for non-euroThe case for non-euro

• 1) EU nations are not a OCA, so they are gonna need nation-specific macroeconomic policies.

• 2) There are other reasons why monetary union is not a good idea:

a) They would not be able to choose their own preferred best inflation/unemployment combination (since they cannot use exchange rate to compensate inflation differentials)

b) Difference in labour market institutions change supply shock transmissions (and thus weakens OCA-forces)

• c) Interest rate transmission mechanism differ across countries (due to legal system and companies financing), so a common interest rate won’t fit everyone.

• d) Fear for increased divergence.

OCA critiquesOCA critiques• 1. Are asymmetric shocks likely?• 2. Labour market• 3. Different legal system and financial markets• 4. Do difference in growth really matters?

1. How likely are asymmetric shocks?1. How likely are asymmetric shocks?

• Two opposite views:• 1) Integration increases symmetry• 2) Integration decreases symmetry

• 1) As trade and economic integration advance, industrial structure (from an industrial point of view) and business cycle (from a macroeconomic point of view) are more synchronized

• 2) The more integrated the market, the more room for specialization and core-periphery patterns (concentration of industrial activities).

• Good review and discussion (pag.26 e 27).• Evidence seems to point out that integration

helps business cylce synchronization (how often do you observe recession in France and boom in Spain?). Business cylce is now even harmonized across the Atlantic.

• Are we sure that other monetary areas (Russian Federation, US) are more optimal as far as asymmetric shocks are concerned?

• The other OCA feature (mobility of labour) actually seems more of a problem; not so much because it is prevented (it is the second defining feature of economic union, second floor of the building), but because of cultural and language barriers.

2) Labour market differences2) Labour market differences• Common monetary policy will tend to harmonize

de facto wage bargaining process, since potentially different wage claims face now the same monetary policy reaction (“I will / won’t accomodate more inflation deriving from your wage demands”).

• Virtually every ECB Monthly Bulletin (one is in your reading material) contains call for EU-wide wage moderation.

3) Different legal and financial 3) Different legal and financial systemsystem

• Economic integration means also financial market integration, a largely incomplete process (Week 10).

• Most of the systematic differences in monetary policy transmission (different effects of interest rate movements) were due to underlying difference in inflation rates.

• In high inflation countries, short-term government bonds prevails (short-term maturity) because no one wants to see the value of their money eroded by inflation. As a result, an increase in interest rate has more severe immediate consequences for high-inflation country’s governments and corporations.

• But as inflation differentials disappears (as it is the case in a monetary union), also do these differences.

NEXT WEEKNEXT WEEK• The most important counter-

argoment to OCA theory:• How effective are national

monetary policies? (ch.2, par.2)