Download OPTIMAL CURRCENCY AREA II

OPTIMAL
CURRENCY
AREA II
WEEK 3
Chapter 2 and 3
Chapter 4 (reading)
Lecture plan
• 1. Analysing monetary union costs:
how effective are national
macroconomic policies?
• 2. The benefits of a single currency
The effectiviness of national
macroeconomic policies
• Monetary and exchange rate policies’job is to
offset shocks
• a) permanent
• b) temporary
• Monetary policy (decrease in i, and subsequent
decrease in E under flexible exchange rate
regime)
• =
• Exchange rate policy (decrease in E under fixed
exchange rate regime)
Permanent shock
• Permanent shift in demand from French to
German products.
• If France doesn’t want (or is not in the
position) to wait for the necessary supply
adjustment to occur, then it can
implement expansionary
monetary/exchange rate policy to shift
back AD curve.
• Devaluation raises imports prices, and
shifts AS curve leftward (even further
away if wage-setting process is such that)
• In the long-run, expansionary policy will not
restore the original equilibrium
• Once again, we notice that the “devil” lies in the
aggregate supply dynamics through the labour
market.
• Devaluation drug.
• What would be the situation in a monetary
union?
• In both cases, after a permanent demand shock,
France has to be willing to accept a decline in the
real wage (either through AS rightward shift, or
devaluation)
• Maybe it can be more politically sustainable, but
economically speaking it all comes down to that.
Temporary shock: the
Barro-Gordon model
• When we face a temporary shock, we are in the
classic macroeconomic situation (stabilization
policy).
• Here we have a classic anti-euro argument: if
France is hit negatively and Germany positively,
under a monetary union ECB should do nothing
(the two shocks offset each other)
• Instead, under national macroeconomic policies,
each country can best pursue its own stabilization
policy.
• How effective are these national
stabilization policies?
Barro-Gordon in words
• Before Barro-Gordon: a country can choose its
most preferred combination on the inflationunemployment frontier
• Do you wanna have less unemployment….? You
just have to bear some more inflation (brought
about by AD shifts, due to macroeconomic
policies).
• The crucial role of expectations: expectations
matter. High inflation today means that
people will expect high inflation tomorrow,
and this will actually bring about more
inflation tomorrow.
• Phillips curve (negative relationship between
inflation and unemployment) is not stable.
• Whatever increases inflation expectations moves
Phillips curve upward
• And what would that be…? Inflation!
• If I push aggregate demand up today, I will
absorb more inflation at the expense of more
inflation.
• But this additional inflation won’t stop here…..it
will increase inflation expectations for tomorrow,
and this will actually increase inflation tomorrow,
even if unemployment does not move.
• There is an independent (=not unemployment)
reason why inflation can raise…..inflation
expectations!
• In the long-run there is no trade-off to be
exploited between inflation and
unemployment…..sooner or later, you will find
yourself on a vertical line (long-run Phillips curve)
• So it’s not true that a country (outside a
monetary union) is free to choose its most
preferred combination. Unemployment
equilibrium level is pinned down by the natural
level (=potential leve ) of output
• In the long-run.
• ….maybe we can still rely on the short-run?
• (skip 2.4, we’ll save it for later)
• Monetary policy is useless if used in a
discretionary way; the more rational
expectations are, the more useless monetary
policy is.
• The key is that the private sector is aware of
monetary policy’s “incentive to cheat”, and act
accordingly.
• The result of the process is that inflation rate will
be higher than the one announced by central
bank.
• How does it happen?
The process in steps
• 1) CB announces =0.
• 2) Private sector knows that once they fix their
nominal variables (w and p) based on CB’s
announcement, CB will have anyway the
incentive to reduce unemployment at the
expense of more inflation (surprise inflation). In
that case, private sector will suffer of a reduction
in purchasing power.
• 3) Based on 2), private sector will increase their
inflation expectations, and this will actually
increase  (Phillips curve shifts upward).
• 4) The process ends only on the vertical Phillips
curve, where inflation expectations are met.
The hijacking
• 1) A given country announces that in case of
hijacking it will never negotiate.
• 2) A hijacking does occur, with 200 hostages, and
ask for a small ransom. What’s the optimal action
by authorities? To give in, and save 200 lives.
• 3) Knowing 2), terrorists around the world won’t
believe further announcements by government,
and will be incentived to hijacking.
What’s the solution?
• Never negotiate. Gain the necessary
credibility so to curb any
expectations by terrorist.
• Be credible. Persuade the public that,
no matter what, CB will never
implement “surprise inflation” (i.e. it
will never try to exploit the short-run
trade off to reduce unemployment
below the natural level).
So what are we saying?
• 1) Inflation-unemployment trade off does not
exist in the long-run, due to AS shifts (increase in
production costs)
• 2) Inflation-unemployment trade off might not
even exists in the short-run, due to private sector
expectations and lack of credibility by CB (private
sector is aware of CB’s incentive to deviate from
zero inflation announcement, and thus update
inflation expectations). As a result, inflation will
be inefficiently higher.
• A solution to 2), is to “tie CB’s hands”: make
them independent from political power and
credible.
•
•
•
•
•
•
Bank of Italy’s “divorce” (1978)
Volcker (1979)
Bundesbank
Bank of New Zealand
Bank of England (1997)
ECB (1999)
• All round the world, CB realized that establishing
a sound reputation of credibility (“I will stick to
my inflation goal and won’t try to “cheat” once
inflation expectations are formed”).
In open economy
• Proceeding with out initial analogy, just replace
“inflation rate target” with “exchange rate target”
• CB can exploit the trade-off by creating surprise
inflation (by pursuing expansionary monetary
policy)
• as well as
• creating surprise devaluation
• In both cases we’re talking about
expansionary macro policies that won’t
accept the natural level of output and try to
push the economy above it.
• Do you mean that if an economy is featured by
low potential output growth it should just learn to
live with it?
• No.
• Just solve the problem with adequate means.
• Raise the potential growth (non-inflationary
growth).
• Total factor productivity (R&D, human capital,
innovation,technology, social and economic
infrastructure, stability, protection of property
rights….whatever helps capital and labour do
their job)
• Increase in labour force (participation in the
labour market).
• If you can’t do that (because it’s too hard and/or
it takes too long), you are surely tempted to raise
output growth simply by “injecting
drugs”:Expansionary monetary/exchange policy
• But this won’t bring you any benefits in the longrun (output goes back to its natural level with
higher prices), and not even in the short-run
(price setting by private sector will take into
account CB opportunistic behaviour).
• Economics has never historically agreed on the
speed of the latter process (monetarists: it
happens instantaneously. Keynesians: it happens
very slow because of nominal variables rigidities).
• But they agree on the fact that it does happen,
sooner or later.
• So we found out that macroeconomic policies
need to be handled carefully.
• If they are used to push output above potential,
they are damaging. So in this respect, countries
forming a monetary union loose a dangerous
temptation.
• But we still have a powerful argument to
fight……what if they are used against shocks?
Would then be a more significant loss?
CB reaction to supply shock
• When a supply shock occurs, Phillips curve shifts
rightward (i.e. more inflation for any given level
of output).
• Then we face the macroeconomic policy dilemma
(Week 1):
• do I stabilize unemployment/output (at the
expense of more inflation)?
• or do I stabilize inflation? (at the expense of
more unemployment/less output)
• The choice depends essentially on CB’s
preferences.
a) If CB cares a lot about employment (i.e. attach a
relatively high weight to employment
stabilization), the resulting inflation bias will be
higher
b) If CB cares a lot about inflation (i.e. attach a
relatively hight weigh to inflation stabilization)
then inflation will be stabilized at the expense of
more unemployment.
…..don’t you think it should be countries’ business?
• a) Inflation is bad. Don’t forget that. Supply
shocks are indeed very hard to deal with, but
there is a way to do that without worsening
inflation: facilitate market adjustment (wage
moderation, costs reductions, technology
improvement)
• b) If you don’t believe a)……. Remember the
three prices of money……..if we harmonize two of
them (interest rate, exchange rate) we’ll have to
deal with the third one as well (inflation rate).
• And if we have to do that, we should harmonize
the ultimate determinants of inflation bias……..
• Different central banks’preferences.
SUMMING UP ON M.U.COSTS
• They are not as evident as they looked at first
sight, aren’t they?
• Asymmetric shocks (at the heart of OCA theory)
are not likely.
• Countries are indeed different in some aspects
(labour market, financial market) that can play a
role in increasing divergence after a shock. But:
a) Are we saying that countries must be equal
in all respects to be able to form a monetary
union?
b) Further integration step will (have to)
harmonize those differences
• Countries are not really free to choose their most
preferred combination of inflation-unemployment
trade off, because in the long-run there is simply
no trade off
• And in the short-run?
• If macroeconomic policies are used to push ouput
above potential: then loosing them (by joining a
monetary union) is a good thing.
• If macroeconomic policies are used to offset
asymmetric supply shock: then if we want to
create a single currency we also have to
harmonize inflation, and thus we have to
harmonize CB’s preferences on inflation (and
remember that inflation is bad). But what are
asymmetric supply shocks?!?!?!
• If macroeconomic policies are used to offset
asymmetric demand shock:
• Go back to point 1): how likely they are
• All right, all right…..theoretically, this is indeed a
true cost of a monetary union.
• But what about the benefits?
The benefits of a single
currency
• Macroeconomic costs.
• Microeconomic benefits.
a) elimination of transaction costs
b) elimination of exchange rate risk
c) international currency
a1)Direct benefits from elimination of
transaction costs
• It is the most visible (although less
quantifiable) gain from a monetary union.
• We might try to quantify the benefits in
terms of commissions, and so on….
• But we know the most important issue
here…..without the single currency, all the
previous integration steps would have
been meaningless (supermarket with
different currencies).
• Which leads us to….
a2)Indirect benefits from elimination of
transaction costs
• Price transparency
• Goods and services prices are easily comparable
across the Union.
• This effect is greater the more competition we
have in the single market (link with Andrea
Mantovani’s course).
b) No exchange rate risk
• Uncertainty about the future value of exchange rate (under
a flexible regime) can have severe consequences on:
• a) trade
• b) investment (real and financial)
• c) growth
• d) consumption (through imports)
• So why don’t you adopt a fixed exchange rate regime?
• The required macroeconomic harmonization (“the three
prices of currency”) is impossible under free movement of
capital (“second floor” of the European integration).
c) international currency
• Creating a new currency which is likely to be
adopted outside the area has two types of
benefits:
• a) Balance-sheet of CB increases (and decreases
passivity on balance of payment capital account)
• b) financial market expands (week 10)
Costs vs Benefits (read ch.4)
• No doubt the greater cost of forming a monetary
union is the lost of national macroeconomic
stabilization policies after asymmetric demand
shocks.
• This remark can surely be mitigated by the
deeper analysis we carried out on aggregate
demand management. But it still remains.
• Benefits are also noteworthy: all the advantages
from having a common market cannot be fully
exploited without a single currency.
• And don’t forget the foundations of the building.
NEXT WEEK
• What we know:
• a) What is EU integration
• b) What is macroeconomic policy and how it
works
• c) Costs (lost of most national macro tools)
and benefits (micro benefits and full
integration) of a monetary union
• What we’ll talk about next week:
• Since EMU means having a single central
bank…how does ECB work?