University of Canterbury course ECON339: Lecture 3

1. ECON339
EURO339
Lecture 3: Optimum
currency areas and
European monetary union
January 2012

2. ECON339 / EURO339
Overview
 The exchange rate and monetary policy
 Types of exchange rate regime – what are the choices?
 Monetary union, optimum currency areas and the
European Union
2

3. ECON339 / EURO339
The eurozone (17)
 1999:
Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxe
mbourg, Netherlands, Portugal, Spain
 2000: Greece
 2007: Slovenia
 2008: Cyprus, Malta
 2009: Slovakia
 2011: Estonia
 Sweden, Denmark, UK opt-out – other 7 have to join
 San Marino, Monaco and Vatican City – with agreement
 Andorra, Kosovo and Montenegro – without agreement
(≈“dollarisation”) 3

4. ECON339 / EURO339
The eurozone today
4

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Background theory
 A quick refresher on basic macroeconomic principles
 Application of these principles to the choice of exchange
rate regimes
 Europe‟s monetary integration is a history of seeking
exchange rate stability
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6. ECON339 / EURO339
The question and the answer
 The question: what to do with the exchange rates?
 The answer: there is no best arrangement
 It is a matter of trade-offs
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7. ECON339 / EURO339
Three basic principles
 Long term: neutrality of money
 In the long run, money, the price level and the exchange
rate tend to move proportionately
 Short term: non-neutrality of money
 Sticky prices mean real short-run effects
 Interest parity condition
 With integrated capital markets r = r*
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8. ECON339 / EURO339
Long-term: neutrality of money (1)
Annual averages Comparison between
25
France and Switzerland
20
Growth rate in France less
15 growth rate in
Switzerland
10
5
0
Year to year:
-5
nothing really visible
-10
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
Money grow th Inflation
Exchange rate
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9. ECON339 / EURO339
Long-term: neutrality of money (2)
Annual averages Five-year averages
25 25
20 20
15 15 Five-year
10 10 averages:
5 5 something
0 0
emerges
-5 -5
-10 -10
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
Money grow th Inflation Money grow th Inflation
Exchange rate Exchange rate
9

10. ECON339 / EURO339
Long-term: neutrality of money (3)
Annual averages Five-year averages Ten-year averages
25 25 25
20 20 20
15 15 15
10 10 10
5 5 5
0 0 0
-5 -5 -5
-10 -10 -10
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
Money grow th Inflation Money grow th Inflation Money grow th Inflation
Exchange rate Exchange rate Exchange rate
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11. ECON339 / EURO339
Long-term neutrality of money in
AS-AD model
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PPP: an implication of long-term
neutrality (1)
 Absolute purchasing power parity
 Based on “law of one price”
 So long-run equilibrium exchange rate must adjust to
equalise purchasing power of different currencies
 The real exchange rate:
 defined as = EP/P*
 if absolute PPP, then EP = P*
 eg, if X is NZ$2.50 and US$2.00
 then E = US$2.00/NZ$2.50 = US$0.80/NZ$ for PPP
 so =1
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Burgernomics

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PPP: an implication of long-term
neutrality (2)
 The real exchange rate with relative PPP:
 defined as = EP/P*
 PPP: E offsets changes in P/P*
 so is constant
 Equivalently: ΔE ΔP * ΔP
E P* P
 or e = п* - п
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15. ECON339 / EURO339
PPP: an implication of long-term
neutrality (3)
France and Switzerland: averages 1951-2004
Average money growth: France less Switzerland 2.5
Average inflation: France less Switzerland 2.4
Average appreciation CHF vs. FRF 3.0
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16. ECON339 / EURO339
PPP: an implication of long-term
neutrality (4)
600
500
Germany and the
400
UK (1951-2004)
300
200
100
0
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
Nominal Exchange Rate Real Exchange Rate 16

17. ECON339 / EURO339
Caveat: the Balassa-Samuelson Effect
(1)
 Consumer price levels in wealthier countries are systematically higher
than poorer ones – why?
 Most workers in rich countries have higher productivity than in poor
countries
 But burger flippers have same productivity everywhere (in burgers
per hour)
 To get burger flippers in rich countries, have to pay more than in poor
countries
 So burgers cost more in rich countries
 CPI is made up of:
 local goods (which are expensive relative to tradables in rich countries)
 tradables, which have the same price everywhere
 So the price level is higher in more productive, richer, economies
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18. ECON339 / EURO339
Caveat: the Balassa-Samuelson Effect
(2) – RER ( ) rises with convergence
Average annual changes vis-à-vis the Eurozone
(1993-2005, % per annum)
Czech Hungary Poland Slovak
Rep. Rep.
Real appreciation 4.4 3.4 2.9 3.5
Inflation differential 3.6 10.3 8.7 4.2
Nominal appreciation 0.8 -6.9 -5.8 -0.7
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19. ECON339 / EURO339
Short-term non-neutrality of money
 From AD-AS: the short-run AS schedule
 Monetary policy matters in the short run
 Channels of monetary policy:
 the interest rate channel (cheaper loans)
 the credit channel (more liquidity = more credit)
 the stock market channel (wealth effect)
 the exchange rate channel (cheaper exports) – very
important channel in open economies
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Short-run AS and the real economy
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Exchange rate regimes and policy
effectiveness
Fixed exchange rate
 no independent
monetary policy
 money is endogenous
Flexible exchange rate:
 no effect of fiscal policy
 the exchange rate
offsets fiscal policy
effects
Interest parity
condition r = r*
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Exchange rate regimes and policy
effectiveness
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Why does the choice of exchange
rate regime matter?
 In the short run, changes in E are mirrored in changes
in = EP/P*…
 …because P and P* are sticky
 In the long run, is independent of E…
 …because P adjusts
 The choice of an exchange rate regime matters in the
short run because prices (and wages) are sticky
 The choice of exchange rate regime determines the
effectiveness of monetary and fiscal policy to absorb
shocks
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24. ECON339 / EURO339
What’s on the menu?
 Free floating Flexible
 Managed floating
 Target zones
 Crawling pegs
 Fixed and adjustable
 Currency boards
 Dollarization/euroization
 Monetary union Fixed
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The choice of an exchange rate
regime
 The monetary policy instrument:
 flexible exchange rates
 can be useful to deal with cyclical disturbances
 can be politically abused (independent central banks)
 The fiscal policy instrument:
 fixed exchange rates
 can also deal with cycles, but can also be politicised
(political cycles)
 deficits can lead to unsustainable public debt
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26. ECON339 / EURO339
The Two-Corners Solution (1)
 Only pure floats or hard pegs are robust:
 intermediate arrangements (soft pegs) invite
government manipulations, over or under valuations
and speculative attacks
 pure floats remove the exchange rate from the policy
domain
 hard pegs (eg, currency boards) are unassailable…..
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27. ECON339 / EURO339
….although Argentina’s currency board
collapsed in 2002
 Not a true 100% backed currency
board
 Argentine defaulted on external debt
in 2002
 Unemployment more than 25%
 Massive capital outflows, runs on
banks
 Peso depreciated 75% after being
devalued and floated
 Michael Bleaney (2004), „Argentina's
Currency Board Collapse: Weak Policy
or Bad Luck?‟ The World Economy, 27
(5), 699–714
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28. ECON339 / EURO339
Hong Kong currency board 1997-98
 Aftermath of 1997 Asian financial crisis, risk re-priced, Asian
currencies vulnerable
 Hong Kong dollar pegged to US$ through 100% currency
board
 First speculative attack – investors short HK$
 HKG raised interest rates
 Second double-pronged speculative attack – investors short
HK$ and HKG shares to force HKG to float to prevent collapse
of stock market
 HKG raised interest rates
 And OMO in stock market, bought 40% of shares to defend
market, banned short-selling
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29. ECON339 / EURO339
The road to monetary union
 EU has also regarded exchange rate volatility as an
obstacle to free trade in goods, services, labour and
capital
 History of European attempts to “fix” cross-rates
 The European Monetary System, deutschmark bloc and
the 1992-93 exchange rate crises
 Monetary union (hard pegs, then single currency)
emerged as preferred policy choice
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30. ECON339 / EURO339
Benefits and costs of monetary
union
 The benefits:
 Eliminate exchange rate uncertainty (promote cross border
trade, investment)
 Eliminate transactions costs (with single currency)
 Transparent prices (promote competition)
 Low, stable inflation (lower nominal interest rates)
 The costs:
 Loss of monetary sovereignty (independent monetary policy
with flexible exchange rate)…
 …which matters in presence of price and wage stickiness and
asymmetric shocks
 Risk of sovereign default (more next week) 30

31. ECON339 / EURO339
Benefits and costs are a function of the
number of countries in the monetary union
 The benefits:
 Money exhibits increasing returns to scale (network
externalities) – the more people accept a currency, the more
useful it is
 A world-wide monetary union (“currency area”) is the way to
maximize these benefits
 The costs:
 As size of (currency area) grows, greater diversity of national
macroeconomic conditions
 Loss of monetary sovereignty (independent monetary policy
with flexible exchange rate)…
 …and greater likelihood of asymmetric shocks
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32. ECON339 / EURO339
The economic toolkit
 There must be
benefits and
costs involved
in adopting a
common
currency…
 …and so an
optimum size
for the
currency area
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33. ECON339 / EURO339
The key is asymmetric shock
 The benefits argue for one worldwide currency
 The costs depend on asymmetric shocks which affect one
country more than others……
 …..so that „one size‟ monetary policy does not fit all
countries
 Look at asymmetric shocks:
 How do they create trouble?
 What makes them more likely?
 What makes them less painful?
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34. ECON339 / EURO339
A demand shock: how does the
exchange rate help?
Supply of domestic goods rises
as RER appreciates –
profitability increases as some
costs tied to foreign prices
Demand for domestic goods
falls as RER rises, switch to
foreign goods
Could use RER in terms of
production costs EW/W*, since
costs feed into prices
Need P, W to fall or
E to depreciate 34

35. ECON339 / EURO339
Symmetric shock
Same demand shock in two similar countries that share the same currency
and, therefore, exchange rate: no problem.
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36. ECON339 / EURO339
Asymmetric shock
Only country A is affected with a common currency: big problem!
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37. ECON339 / EURO339
Asymmetric shock: response 1
Country A wants a depreciation to λ1. With sticky prices, country B faces
inflationary excess demand. No „one size fits all‟.
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38. ECON339 / EURO339
Asymmetric shock: response 2
Depreciate common currency to „correct‟ average RER, λ2: excess supply in
country A, excess demand in country B. Still no one sizes fits all.
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39. ECON339 / EURO339
Asymmetric shock: response 2
(cont’d)
Excess supply in country A -> recession, eventually prices fall; excess demand in
country B -> inflation, prices rise. Equilibrium restored.
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40. ECON339 / EURO339
Implications of asymmetric shocks
 Both countries are hurt when they share the same currency
 ….also if a symmetric shock creates asymmetric effects
(because economic structures different)
 This is an unavoidable cost
 So:
 What reduces the incidence of asymmetric shocks?
 or
 What makes it easier to cope with shocks when they occur?
 The analysis develops six OCA criteria
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41. ECON339 / EURO339
Six OCA criteria
 Three classic (economic) criteria
 Labour mobility (Mundell)
 Product diversification (Kenen)
 Openness (McKinnon)
 Three political criteria
 Fiscal transfers
 Homogeneity of preferences
 Solidarity
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42. ECON339 / EURO339
Criterion 1: labour mobility (1)
In an OCA, labour moves easily across national borders, from country
A (recession) to B (inflation). Equilibrium restored at λ2.
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43. ECON339 / EURO339
Criterion 1: labour mobility (2)
 In an OCA, labour moves easily across national
borders…..
 …..but:
 labour mobility is easy within national borders
(culture, language, legislation, welfare, etc)
 financial vs physical capital – financial capital mobile, but
workers need physical capital as well, immobile in short
run
 in presence of country specialization, labour skills also
matter
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44. ECON339 / EURO339
Criterion 2: production diversification
 Most shocks associated with changes in spending
patterns, new technologies which bring about new
product choices
 If countries‟ production and exports are widely
diversified and of similar structure, then…..
 …there are few asymmetric shocks and each is likely to
be of small concern
 Such countries form an OCA
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45. ECON339 / EURO339
Criterion 3: openness
 Countries which are very open to trade and trade
heavily with each other form an OCA
 Distinguish between traded and non-traded 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
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46. ECON339 / EURO339
Criterion 4: fiscal transfers
 Countries that agree to compensate each other for
adverse shocks form an OCA
 Transfers can act as an insurance that mitigates the
costs of an asymmetric shock
 Transfers exist within national borders:
 implicitly through the welfare system
 explicitly in federal states
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47. ECON339 / EURO339
Criterion 5: homogeneous
preferences
 Countries that share a wide consensus on the way to
deal with shocks form an OCA
 Matters primarily for symmetric shocks:
 prevalent when the Kenen (product diversification)
criterion is satisfied
 May also help for asymmetric shocks:
 better understanding of partners‟ actions
 encourages transfers
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48. ECON339 / EURO339
Criterion 6: solidarity
 Countries that view themselves as sharing a common
destiny better accept the costs of operating an OCA
 A common currency will always face occasional
asymmetric shocks that result in temporary conflicts of
interests:
 this calls for accepting such economic costs in the name of
a higher purpose
 Greek bail out?
48

49. ECON339 / EURO339
A summary
Very Product
Open differentiation
(McKinon) (Kenen)
Low likelihood
of asymmetric
shocks
YES: NO:
OCA Need adjusment
Labour
mobility
(Mundell)
YES: NO:
OCA need adjustnent
Flexible
wages and
prices
YES: NO:
OCA need political
support
Homogeneity
Transfers of Solidarity
preferences 49

50. ECON339 / EURO339
Is Europe an OCA?
A synthetic OCA
index:
 How much should
countries have
adjusted ER vis-à-
vis DM in response
to asymmetric
shocks?
 The bigger the
shocks and the
more adjustment
needed, the higher
the index
50

51. ECON339 / EURO339
Inside the OCA Index: labour mobility
(1)
 The labour mobility criterion cannot be black-and-white
 The migration response to economic incentives must factor
in many costs:
 moving costs
 risk of becoming unemployed
 longer run career opportunities
 family prospects
 eligibility to welfare
 taxation
 cultural/linguistic differences
 national attachment
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52. ECON339 / EURO339
Inside the OCA Index: labour mobility
(2)
 An international
comparison suggests
that labour mobility is
low in Europe
 Low labour mobility
implies that
unemployment bears
much of the burden of
adjustment to shocks
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53. ECON339 / EURO339
Inside the OCA Index: diversification
 Trade dissimilarity
index:
 How dissimilar is trade
from Germany
(benchmark)?
 Most EU countries have
a diversified production
structure (intra-
industry trade
dominates)
 The Kenen criterion is
broadly satisfied and
well explains which
countries joined the
euro area
53

54. ECON339 / EURO339
Inside the OCA Index: openness
 Most EU countries are very open (ratio of X+M to GDP)
 The McKinnon criterion is broadly satisfied
Austria 52.3 Cyprus 48.3 Denmark 42.8
Belgium 87.2 Czech Republic 76.0 Sweden 43.9
Finland 35.4 Estonia 92.0 UK 27.9
France 27.2 Hungary 70.1
Germany 39.9 Latvia 55.0 Bulgaria 65.9
Greece 25.5 Lithuania 56.9 Croatia 54.4
Ireland 72.6 Malta 81.8 Romania 39.3
Italy 27.9 Poland 40.9 Turkey 36.5
Luxembourg 133.3 Slovak Republic 83.6
Netherlands 66.4 Slovenia 63.1
Portugal 36.2 US 13.8
Spain 29.5 EU-25 10.7 Japan 13.5
54

55. ECON339 / EURO339
Is Europe an OCA: a complication…..
Asymmetric effects of symmetric shocks: effects on GDP and prices of a
change of the common interest rate
55

56. ECON339 / EURO339
Inside the OCA Index: political
criteria
 The EU does not satisfy the transfer criterion
 The overall EU budget is entirely used for
agriculture, cohesion, administration
 Net transfers not related to pc GDP
 Little is known about:
 Homogeneity of preferences
 Commonality of destiny…although most public opinion in
favour of EU
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57. ECON339 / EURO339
Commonality of destiny: poll results
EU25
SI
SK
HU
IT
ES
Do you support European
EL
BE
PL
political union?
CZ
DE
CY
LU
(Eurobarometer, 2005)
LV
PT
MT
LT
EE
FR
NL
IE
DK
SE
AT
FI
UK
0% 20% 40% 60% 80% 100%
For Against Don't know 57

58. ECON339 / EURO339
Overall?
The OCA glass is half full, or half empty
58

59. ECON339 / EURO339
History never ends: the endogeneity
of OCA criteria
 Living in a monetary union may help fulfil the OCA criteria
over time
 Would the US be an OCA without a single common
currency?
 Will the existence of the euro area change matters too?
59

60. ECON339 / EURO339
Endogeneity: EMU and labour markets
 Mobility may not change much, but wages could become
less sticky
 Two views:
 the virtuous circle: labour markets respond to enhanced
competition by becoming more flexible
 the hardening view: labour markets respond to enhanced
competition by increasing protective measures that raise
stickiness
 The jury is still out
60

61. ECON339 / EURO339
Endogeneity: will diversification
grow or decline?
 Argument 1: intra-industry trade will grow
 Argument 2: specialisation will increase
 No firm conclusion so far
61

62. ECON339 / EURO339
Endogeneity: will economies become
more open?
 Little evidence that reducing exchange rate volatility
increases trade
 Mounting evidence that eliminating exchange rate volatility
by adopting a common currency increases trade a lot:
 estimates range from 50 per cent to 100 per cent
 the „border effect‟ provides similar estimates – without common
currency, border prices can be very different (eg, US – Canada)
62

63. ECON339 / EURO339
Endogeneity: are the political criteria
endogenous?
 Transfers:
 currently no support for more taxes to finance
transfers
 Homogeneity of preferences:
 no presumption that it will change soon
 Commonality of destiny:
 no presumption that it will change soon
63

64. ECON339 / EURO339
Conclusions
 Basic principles:
 Long-term neutrality of money (PPP)
 Short-term monetary policy matters, with sticky prices
 Choice of exchange rate regime impacts relative effectiveness of
monetary and fiscal policy
 EMU seen as the solution for the EU
 The OCA criteria do not send a clear signal:
 The OCA criteria tell us where the costs will arise:
 labour markets and unemployment
 political tensions in presence of deep asymmetric shocks
 But real problem in the current EU crisis has been reliance on fiscal
policy and government deficits and insolvency – agenda for Lecture
4
64