Download The Costs of a Single Currency

Classes and Lectures
• There are no classes in week 24, apart from the
cancelled ones
• You’ve already had 9 classes, as promised, and no
doubt you’re keen to revise…
• Answers for Question Sheet 5 are on the module
website
• There is no EC1001 lecture this Friday 11 May. There
will be 2 revision-based lectures in week 24 (17 and
18 May)
The Euro
(Chapter 38 in Mankiw and Taylor)
Plus in this lecture we will run through
the AD/SRAS,LRAS model again – since
this should have come up in your
assessed essay – and you need to
know this model for the exam
But first, as this is important looking
forward to the exam, we’ll run through
the coursework essay
In particular, we will re-consider the
AD/SRAS,LRAS model and consider how it
lets us distinguish the likely short and long
run effects of QE
How can the Bank of England increase the
money supply?
• OMOs: buy government bonds (outright)
• Refinancing (repo) rate: An OMO but not outright; a
loan. Decrease this rate encourages banks to borrow
from the money market
• Reserve requirements (money multiplier). Decrease
the reserve requirement (if they exist) to increase
the money created by bank
• QE: involves purchase of longer-dated bonds than
traditional OMOs. Also wider set of assets bought
How precisely can the Bank of England
increase the money supply?
• Cannot control the broad money supply perfectly
– Money multiplier is not under the BoE’s control, in a
fractional reserve banking system
• The BoE does not control the amount of currency that
households choose to hold relative to deposits
– If households decide to hold relatively more currency, banks
have fewer reserves and the money supply decreases
• The BoE cannot control the amount banks choose to hold
as excess reserves
– If bankers decide to lend out less of their deposits, the money
supply will decrease
– Currently banks are rebuilding their balance sheets…
What should we expect to be the macroeconomic
consequences of the ‘quantitative easing’
recently undertaken by the Bank of England?
• Make a short versus long run distinction
• Use economic models to formalise your argument
• QE designed to boost nominal AD
– Transmission mechanism is it encourages banks
and others who receive this central bank money
to lend it out (loanable funds increase) and
thereby stimulate AD (improve banks’ balance
sheets, their liquidity)
– Focus on macro not finance implications
Long run (LR)
• “Quantity Theory” (Friedman) – effect on inflation.
One-for-one if “V” (velocity of circulation) constant.
Could use MS/MD graph, with P or 1/P on y-axis
• “Classical dichotomy” and “Monetary Neutrality”:
Money increase has no effect on real variables,
including real GDP, unemployment, real wages and
real interest rates (but via the Fisher effect the
nominal rate increases)
• Exchange rate effects: PPP – inflation leads to
depreciation
Short run (SR)
• IS/LM (interest rates ↓ and real income ↑, as LM
shifts to the right)
• AD-SRAS curve (real output ↑, prices ↑, extent
depending on slope of SRAS curve)
• SR Phillips Curve (unemployment ↓ as inflation ↑)
• Also open economy effects, as QE leads to exchangerate depreciation, via uncovered interest rate parity
in SR and PPP (and inflation) in the LR
– Use graph in Mankiw & Taylor p.695 which sees supply of
loanable funds increase (in book it decreases, so reverse
the conclusions), hence with r lower, NCO is higher so real
exchange rate falls
Integrated analysis: AD/SRAS,LRAS model
• The short run effects may be quite persistent (i.e. the
long run effects maybe a long time coming) in the
current climate, given the economy is in recession and
arguably there’s lots of spare capacity in the economy
(so the SRAS curve is pretty flat)
• A SR effect on real output depends on inflation being
higher than expected (surprise/unexpected inflation)
– Due to sticky wages, sticky prices or misperceptions
– Shifts AD to the right, along SRAS curve – for fixed
inflationary expectations; explained by LM curve
shifting to the right along a given IS curve (so r
lower and y higher)
QE is expected to boost AD, to some degree
A Monetary Injection
(a) The Money Market
Interest
Price
rate
level
Money supply,
MS2
MS1
1. When the BoE
increases the
r1
money supply . . .
P
(b) The Aggregate-Demand Curve
r2
AD2
Money demand
at price level P
0
2. . . . the equilibrium
interest rate falls . . .
Aggregate
demand, AD1
Quantity
0
Y1
Y2
Quantity of output
of money 3. . . . which increases the quantity of goods
and services demanded at a given price level.
In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium interest
rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in the interest rate
raises the quantity of goods and services demanded at a given price level from Y1 to Y2. Thus,
in panel (b), the aggregate-demand curve shifts to the right from AD1 to AD2.
The likely short and long run effects of QE
An increase in Aggregate Demand
Price
Level
Long-run
aggregate supply
AS2
3. . . . but over time, the shortrun aggregate-supply curve
shifts up as P expectations ↑
Short-run aggregate supply, AS1
P3
C
B
P2
A
4. . . . and output returns to its
natural rate.
P1
1. An increase in aggregate
demand . . .
AD1
Y1
Y2
AD2
Quantity of Output
2. . . . causes output to rise in the short run . . .
A rise in aggregate demand is represented with a rightward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output rises from
Y1 to Y2, and the price level rises from P1 to P2. Over time, as the expected price level increases,
the short-run aggregate-supply curve shifts to the left from AS1 to AS2, and the economy reaches
point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve.
In the long run, the price level rises to P3, and output returns to its natural rate, Y1 – as the
Quantity Theory and monetary neutrality imply
Similar story with short and long run Phillips Curves
Surprise AS curve:
Quantity of output supplied =
= Natural rate of output + a(Actual price level – Expected price level)
European Monetary Union
1. The Euro
2. The benefits and costs of a common currency
3. The theory of optimum currency areas
4. Is Europe an optimum currency area?
5. Fiscal policy and common currency areas
The Euro
• The euro officially came into existence on 1 January
1999 and on 1 January 2002 the first euro notes and
coins began to circulate
• EA countries adopted fixed (in principle irrevocably)
exchange rates
• Why did they give up their own currencies?
– Economic as well as political arguments
The benefits and costs of a common
currency
The Benefits of a Single Currency
• The transaction cost involved in converting
currencies is a deadweight loss, so reducing these
costs by adopting a single currency provides a clear
gain to society
• It is less likely that there will be price discrimination
between countries because a single currency makes
it more difficult to disguise price differences
– Price discrimination again involves a deadweight
loss to society
The Benefits of a Single Currency
• Reduction in foreign exchange rate fluctuations that
create uncertainty for businesses engaging in trade
between EMU countries
– Businesses could always deal with such
uncertainty by engaging in forward foreign
exchange contracts with their banks, but the
banks charge for this service and a single currency
eliminates this (deadweight) cost (loss)
– Encourages trade and investment as the absence
of exchange rate fluctuations makes business
planning easier and may boost investment, with
benefits for long-run economic growth
The Costs of a Single Currency
• The major cost is that a country joining a currency
union gives up:
1. its freedom to set its own monetary policy
(interest rate)
2. and the possibility of macroeconomic adjustment
through movements in the external value of its
currency
The Costs of a Single Currency
• Suppose there is a shift in consumer preferences
away from German goods and in favour of French
goods
• The aggregate demand curve will shift to the left in
Germany and to the right in France, leading to
increased unemployment and downward pressure
on prices in Germany, and lower unemployment and
upward pressure on prices in France
Figure 1 A Shift in Consumer Preferences Away from
German Goods Towards French Goods
If the governments do nothing then the economies will, in the
long run, return to their natural rates of unemployment as
wages and prices fall (relatively) in Germany and SRAS
shifts
The Costs of a Single Currency
• But if the two countries had retained
separate currencies then the short-run
fluctuations in aggregate demand would
have been alleviated by a movement in
the exchange rate
– i.e. AD can shift as the real exchange
rate changes, reflecting changes in the
relative demand for the two currencies
Figure 2 A Shift in Consumer Preferences with Flexible
Exchange Rates
Copyright © 2004 South-Western
The Costs of a Single Currency
• Without this adjustment mechanism,
German policy makers may wish to see a cut
in interest rates to boost aggregate demand,
while French policy makers will be more
likely to favour a rise in the interest rate to
contain inflation
• The ECB would be unable to satisfy both
countries
– Euro implies a “one size fits all” monetary
policy
Optimum Currency Area Theory
• An optimum currency area is a group of countries for
which it is optimal to adopt a common currency and
form a currency union
• OCA theory attempts to specify criteria for the
optimality of a currency union for a given group of
countries
• The qualifier ‘optimal’ is used loosely and should be
taken to refer to the ability of the countries
concerned to limit the costs of monetary union and
enhance the benefits
OCAs: Characteristics That Reduce
the Costs of a Single Currency
• There’s only a short run trade-off between unemployment
and inflation, so the more quickly an economy moves to its
long-run equilibrium after a shock the better
– A high degree of real wage flexibility so that wages
respond strongly to fluctuations in unemployment will
ensure that long-run equilibrium will be restored quickly
following any macroeconomic disturbance
– A high degree of labour mobility between the member
countries of a currency union will also ensure
macroeconomic stability
• In the earlier example, the migration of labour from Germany to France
would alleviate inflationary pressure in France and keep down
unemployment in Germany
OCAs: Characteristics That Reduce the
Costs of a Single Currency
• A high degree of capital mobility can also help
alleviate the problems of asymmetric shocks
– Residents of a country experiencing recession may
borrow money from residents of a country
experiencing a boom to make up for their
temporary fall in income - without domestic
interest rates rising
– Clearly if the demand shocks hitting the EA are
symmetric there is no problem
OCAs: Characteristics that Increase the
Benefits of a Single Currency
• A high degree of trade integration among a group of
countries will lead to greater benefits should those
countries establish a currency union
– As there’s more of a gain from both no
transactions costs and the reduction in exchange
rate volatility
Is Europe an Optimum Currency Area?
• There is lots of within-Europe trade (we can think of
the ratio of intra-EU exports and imports to GDP as a
measure of trade integration)
• But labour and wage flexibility are low in the EA
• So, as we have seen recently, if strong differences
emerge between the EA countries the lack of
independent monetary and exchange rate policy do
matter
– Think of Greece
– Perhaps EA will not survive
Fiscal Policy and Common Currency Areas
• While monetary union prevents independent monetary
policy, countries might retain control of fiscal policy and
use it to ameliorate the loss of monetary policy
– So Germany could expand AD and France reduce it
– Need to think about this possibility both in a fiscal union and
when countries have independent fiscal policies
• Fiscal federalism involves a common fiscal budget and
system of fiscal transfers across countries
– If a currency union had a common fiscal policy then fiscal policy
in the currency union would work much as fiscal policy in a single
national economy works
– The problem might be that taxpayers in one country may not be
happy to see their taxes spent on transfers to residents of
another country
Fiscal Policy and Common Currency Areas
• When countries conduct independent fiscal policy there
is a potential free rider problem in a currency union
– A government issuing a large amount of government
debt pays a lower interest rate on it than it would
have outside the union
• As the other (solvent) countries are seen by the markets to
underwrite the profligate country’s debt
– Unless there was a credible “no bail-out” agreement, so that the
markets do charge the profligate countries higher interest rates
– And other countries pay higher interest rates
– For this reason currency unions may impose rules on
national fiscal policies… ongoing debate in EA
Summary
• A common currency area (a.k.a. currency union or
monetary union) is a geographical area through
which one currency circulates and is accepted as the
medium of exchange
Summary
• The formation of a common currency area can bring
significant benefits to the members of the currency
union, particularly if there is already a high degree of
international trade among them (i.e. a high level of
trade integration)
• This is primarily because of the reductions in
transaction costs in trade and the reduction in
exchange rate uncertainty
Summary
• There are, however, costs of joining a currency
union, namely:
– the loss of independent monetary policy
– and the loss of the exchange rate as a means of
macroeconomic adjustment
• These adjustment costs will be lower the greater is
the degree of real wage flexibility, labour mobility
and capital market integration across the currency
union, and also the less the members of the currency
union suffer from asymmetric demand shocks
Summary
• A group of countries that has a high level of trade
integration, high labour mobility and real wage
flexibility, a high level of capital market integration
and whose member countries do not suffer from
asymmetric shocks, is termed an optimum currency
area (OCA)
• An OCA is most likely to benefit from currency union
Summary
• It is possible that a group of countries may become
an OCA after becoming a currency union, as having a
common currency may further enhance trade
integration, thereby helping to synchronise
members’ economic cycles, and having a single
currency may also help to foster increased labour
mobility and capital market integration