Download Optimal Currency Areas Costs and Benefits compared

Optimal Currency Areas
Costs and Benefits compared
Lotte Ovaere
Louvain Institute for Ireland in Europe – Spring 2012
Introduction
Evaluate decision of EU countries to form a monetary
union
Evaluate economic desirability for new EU member states
to join the EMU
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Costs and benefits compared
Relating benefits and costs to openness of a country
Critical level of openness
Shape and position of cost curve depend on view about
effectiveness of national monetary policies in dealing with
asymmetric shocks
Monetarist view
Keynesian view
Popularity of monetarism since 1980s
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Intra-EU trade
Country
2005 Intra-union exports (% of GDP)
Belgium/Luxembourg
66.7
Slovakia
58.9
Netherlands
51.1
Hungary
43.7
Ireland
34.7
Austria
28.1
Denmark
23.1
Germany
22.0
France
13.7
Italy
12.2
UK
9.8
Greece
4.0
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Monetary union, flexibility and mobility
Degree of wage and price flexibilities influences cost
benefit analysis of MU
Countries with low price and wage rigidities experience
lower costs entering MU
Similarly, higher labor mobility lowers costs of being in a
MU
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Asymmetric shocks and labor market
flexibility
Degree of labor market flexibility (wage flexibility and
labor mobility) determines attractiveness of MU
But! Size and frequency of asymmetric shocks equally
important
Asymmetric shock = differences in industrial structures
between countries
Cost line shifts to the right
Relation labor market flexibility and asymmetric shocks in
a monetary union
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Asymmetric shocks and labor market
flexibility
Central insight Theory of OCA: Benefits of monetary
union depend on balancing asymmetric shocks and labor
market flexibility
Downward sloping OCA curve
Zone to the right of OCA line: OCA zone
Location of EU-25?
Of Euro zone?
And USA?
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Challenge of EU-25: Move into OCA zone
Two strategies
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Reduce degree of asymmetric shocks
Increase degree of flexibility (real wages/labor mobility)
Difficulty with first strategy: little influence of policy
makers
Exception: Political unification
Special problem: Organization of labor union in a MU
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Two opposite requirements for optimal organization:
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In the presence of asymmetric shocks
In the presence of symmetric shocks
Centralized wage bargaining system @ EU level?
Case study: Adjustment process after
asymmetric shock
Early 1980s: severe recession in industrial world
Economic downturn had very different effects on
different countries/regions
Michigan (US) vs. Belgium (EU)
Increase in unemployment much higher in Michigan and
Belgium than in US and EU (respectively)
How did two regions adjust?
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Michigan
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Outward migration: Sizeable fraction of unemployed
moved
Very little real depreciation (few percentage points)
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Only possible through prices (common currency!)
Fiscal policy: Automatic transfer of purchasing power to
Michigan via US Federal transfers and taxes
 Inter-regional solidarity
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Belgium
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Real exchange rate changes: Real depreciation of Belgian
Franc of 20-25%
Restore competitiveness, gradual recovery, significant
narrowing of unemployment difference between Belgium
and EC
Real depreciation: partly nominal devaluations, partly
lower cost and price developments relative to main
trading partners
Very little outward migration of unemployed
Fiscal policy: No EU-federal redistribution
 Intergenerational solidarity
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Costs and benefits in the long run
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Dynamic analysis
Relation between degree of economic integration and
occurrence of asymmetric shocks
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European Commission view of monetary integration
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Optimistic
Krugman view of monetary integration
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Predicts whether progress towards economic integration leads
to economic convergence
Pessimistic
Self-fulfilling character of joining the MU
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Challenge of EMU enlargement: New
members
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Degree of openness
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Asymmetric shocks
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New member states (Central Europe) at least as open to EU25 as ‘old’ EU
New member states more integrated than ‘opt out’ countries
(UK, Sweden and Denmark )
Correlation pattern of demand and supply shocks for some
central European countries very similar to Euro zone
Integration and satisfying optimal currency criteria made easier
by joining Euro zone
Import monetary and price stability
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Staying out leads to large exchange rate volatility
Challenge of EMU enlargement: Original
members
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Wait longer until they reach OCA zone
ECB policy less aligned with their needs (less perceptive
to their national shocks)
Both in optimistic and pessimistic view
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Challenge of EMU enlargement
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Role of ECB
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Can only set one interest rate: fine tuning interest rate impossible
Make sure individual member countries have instruments
to deal with asymmetric developments
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Progress towards labor market reform: Flexibility probably only
available instrument to adjust to asymmetric shocks
Should UK join EMU?
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Cost side
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Openness: UK lowest degree of openness towards rest EU
(except Greece)
Asymmetry:
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Flexibility:
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Demand shocks UK negatively correlated with those in rest of EU
(independent monetary policy)
Supply shocks only weakly correlated with those of Euro zone
UK labor markets more flexible than major Euroland countries
(Germany, France, Italy)
Illustration: UK inflation and unemployment after oil shock (1979) and
recession (1990s) performed much better than in Germany and
France (more rigid labor markets)
Lack of desire to join a MU
Should UK join EMU?
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Benefits
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Similar to those of other countries, but smaller: Benefits of
MU in function of openness
Compensation by special position of City of London as major
financial centre
Conclusion
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If other countries came to a positive cost-benefit analysis, why
not UK?
Remark! Existing EMU members would not benefit from UK
entering: UK represents 20% of Euro zone’s GDP +significant
asymmetric shocks  ECB decisions less consistent with their
needs
Thank you and good luck
with the exam!
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