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Macroeconomics Chamberlin and Yueh Chapter 14 Lecture slides Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Exchange Rate Regimes and International Policy Coordination • • • • • The Choice of Exchange Rate Regime International Policy Coordination Optimal Currency Areas Is Europe an Optimal Currency Area? Should the UK join the Euro? Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Learning Objectives • Determine the advantages and disadvantages of different exchange rate regimes, namely, fixed and floating. • Investigate the subject of international policy coordination, as in an open economy, policies or shocks specific to one country can be transmitted into others. • Understand the concept of optimal currency areas (OCA), and recent examples such as the European Monetary Union (EMU) and the establishment of a single currency in Europe (the euro). Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning The Choice of Exchange Rate Regime • What factors might determine whether or not policy makers opt to fix the exchange rate at a given level against another currency, or let it float, allowing its value to be determined by market forces? • The answer is essentially the regime that policy makers feel will most realistically achieve their economic goals. • Historically, the main goal of governments has been to achieve high and stable economic growth. It is from high long-term economic growth that living standards are improved. The role of government is therefore to manage the economy in order to engineer the conditions that will best achieve this. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning The Choice of Exchange Rate Regime • Objectives: – Exchange rate stability – Price (inflation) stability – Output (business cycle) stability • An evaluation of the advantages and disadvantages of each type of exchange rate regime can be couched in terms of its ability to meet these three objectives. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Exchange Rate Stability • The question of regime choice with respect to exchange rate volatility is fairly trivial; it is obvious that a fixed regime will win here. • Fixed exchange rate regimes, however, only provide a temporary mirage of exchange rate stability. If pressures on a currency continuously build, then the policies required to maintain a fixed exchange rate regime may start to have painful effects on the domestic economy. In such situations, policy makers may eventually decide to abandon the fixed regime, at which point there can be very dramatic movements in the currency. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Stability • A traditional reason for maintaining a fixed exchange rate is in order to control inflation. • UK membership of the Exchange Rate Mechanism (ERM) basically involved fixing the pound against the Deutsch Mark (DM), but was solely motivated to try and import low levels of West German inflation. Mexico has recently tried to fix the value of the Peso against the U.S. dollar, the aim of which is to demonstrate a commitment to low inflation. • There are two reasons why this is the case. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Stability • Firstly, and most obviously, once a country commits to fixing their exchange rate they give up control of their monetary policy. • The Quantity Theory of Money argues that: Mv=PY. • It is assumed that the velocity of circulation is fixed, and that output is always at its equilibrium of full employment level. In this case, it stands that: • Changes in the money supply will have directly proportional effects on prices. %M %P Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Stability • Under a floating exchange rate regime, policy makers may undertake a monetary expansion in order to stimulate the economy. If there are some price rigidities, they may be successful in raising output in the short run, but ultimately the predictions of the Quantity Theory of Money hold true in that output stays at the natural level and prices rise. • In a fixed exchange rate regime, the policy maker forgoes control of the domestic money supply. Any monetary shocks would have to be immediately offset, and therefore will have no consequence for prices. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Monetary Expansion: Floating Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Monetary Expansion: Fixed Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price Stability • There is a second reason why fixed exchange rates might be a useful tool for establishing low inflation. • This is connected with the general maxim that inflation rates cannot permanently differ between two nations who have fixed their exchange rates. This will give the high inflation country an opportunity to import the low inflation from the country with lower inflation. • Membership of a fixed exchange rate regime can create and enforce inflation discipline. Firms are unlikely to increase prices if they know that the exchange rate will not depreciate in order to restore their competitiveness and workers are unlikely to push for higher wages if they know that the result of this will be lower competitiveness and higher unemployment. • As long as domestic inflation exceeds that from overseas, the domestic economy will suffer a loss in competitiveness that pushes output below its natural level. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Higher domestic inflation: Floating Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Higher domestic inflation: Fixed Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Foreign Price Shocks: Floating Exchange Rate Regime • A foreign price shock would improve the relative competitiveness of domestic products, shifting the ISXM schedule outwards. • The economy will move from point a to b, but return to a almost immediately following the domestic exchange rate appreciation. The exchange rate moves to insulate domestic inflation from the overseas price shock. • Remember from the theory of purchasing power parity (PPP): %P %E %P • The change in the domestic price level is approximately equal to the change in the foreign price level and the change in the nominal exchange rate. Hence, if %E %P , then %P=0. • The exchange rate appreciation is sufficient to offset the higher overseas price level. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Foreign Price Shocks: Floating Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Foreign Price Shocks: Fixed Exchange Rate Regime • Under a fixed regime, the economy will not experience the insulating effect of exchange rate movements. • Instead, the foreign price shock would have to be accommodated by an expansionary monetary policy and would be transmitted directly into domestic prices. • This can once again be seen by looking at the relative PPP equation: %P %E %P • Under a fixed regime, it must be the case that %E=0 and %P %P • Therefore, although a fixed exchange rate regime may offer the opportunity of importing lower inflation, the converse must also be true in that it may also offer the opportunity for other countries to export high inflation. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Output Control • When defending a fixed parity becomes excessively painful in terms of domestic output and unemployment, then policy makers may be all too willing to sacrifice it. • The choice of exchange rate regime has consequences for the stabilisation of output at its full employment level. This primarily works through net exports, with movements in the nominal exchange rate affecting competitiveness. • The conventional wisdom is that a floating exchange rate regime is more successful here, as the exchange rate will simply change to offset any demand (ISXM) shocks that hit a country. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Increase in Foreign Prices: Floating Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Increase in Foreign Prices: Fixed Exchange Rate Regime Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Output Control • We have now reached one conclusion, that flexible exchange rate regimes are more successful at insulating the domestic economy from demand shocks. However, it is worth bearing in mind that not all shocks affecting output are necessarily demand shocks; although it is reasonable to argue that these are the most important. A monetary shock will lead to a shift in the LM schedule, which via its effect on the domestic interest rate, can have implications for output. • Therefore, it appears that a second valid conclusion is that countries which are prone to monetary (LM) shocks are more likely to be successful in stabilising output with a fixed exchange rate regime. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Brief Summary • The advantages and disadvantages of each type of regime have been vigorously discussed over the years. • Conventionally, it is argued that fixed regimes are best at achieving nominal (exchange rate and price) stability, whereas floating regimes are better at dealing with real (output, employment) disturbances. • Global Applications 14.2 A Short History of Fixed Exchange Rate Regimes Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning International Policy Coordination • As countries become increasingly open with respect to international trade and capital flows, the linkages among these countries will strengthen. • This will reinforce the spillover and feedback effects of shocks and policies in domestic economies. • There are principally two mechanisms through which these work: exchange rate movements, and aggregate demand. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Exchange rate externalities • This can be seen using the Mundell-Fleming model where policy changes through the impact on the exchange rate has a clear effect on other countries. • The next figures represent the cases when a large country unleashes a fiscal expansion. Panel (a) represents the domestic economy, whereas panel (b) represents the rest of the world. • Some of the initial fiscal expansion has been transmitted overseas through movements in the exchange rate. Equilibrium world interest rates are higher because higher income means higher demand for money. • The expansionary monetary policy of the large country generates a negative externality for the rest of world. The large country gains higher output by depreciating its exchange rate vis-à-vis the rest of the world and improves its relative competitiveness. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning A large country unleashes a fiscal expansion Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning A large country unleashes a monetary expansion Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Aggregate demand externalities • Policy in one country can also directly spill over into others through aggregate demand externalities. • When capital mobility is high, as in the Mundell-Fleming model, the exchange rate is the main source of externality because it reacts quickly and spontaneously to changes in interest rates. • For this reason, it is easier to discern the effects of aggregate demand externalities by assuming no capital mobility. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Expansion by a Large Economy Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Impact on the rest of the world Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Aggregate demand externalities • The aggregate demand expansion in one country has spilled over into the rest of the world. This position, though, is not sustainable. • From the above figures, it is clear that the expanding economy is now running a trade deficit and the rest of the world an offsetting surplus. The deficit country will begin to run down its reserves, at which point the money stock will contract. As the LM curve shifts upwards, the economy will move to point c. The fall in output will offset the initial increase in global demand, so the rest of the world will experience a fall in export demand returning their economies back to point a. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Aggregate demand externalities • Suppose, though, that all the countries in the world unleashed an equal fiscal expansion. The following figure represents the outcome for each country if they all expand simultaneously. • As output has increased in every country, all will experience a rise in exports as well as the initial expansion in aggregate demand. • Therefore, countries can expand without running into trade deficits as before, making the increase in output more sustainable. • This is an example of how coordinating policy can deliver a mutually preferable outcome. As there are potentially very important spillovers among different economies, it is obvious that there might be some benefits from coordinating economic policies. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal expansion by all countries Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Currency Areas • The logic behind the theory of optimal currency areas (OCA) is very simple – it just implies that an economic region is an optimal currency area if the advantages of adopting a single currency outweigh the disadvantages. • A basic cost-benefit analysis can help find the answer to whether a country should join an OCA or not. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Benefits: The GG Schedule • The most obvious benefits are the monetary efficiency gains of a single currency. Trade can now occur without the transactions costs and uncertainty of dealing in different currencies. A single currency also makes it easier to compare prices in different countries; markets will then be more competitive and that would be expected to result in higher welfare. • It is difficult to quantify the exact size of these benefits, but it seems plausible to argue that the gains to a country from joining a monetary union will depend on the degree of economic integration that country has with the area. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Benefits: The GG Schedule • The GG schedule is drawn as an upward sloping schedule, where the monetary efficiency gains from joining a single currency area rises with the degree of economic integration. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Costs: The LL Schedule • Once a country signs up to a single currency, it loses the ability to use monetary policy and the exchange rate to control the economy. This could result in an economic stability loss. • As all the countries in a single currency must have a common interest rate and exchange rate, asymmetric shocks become very difficult to correct. • These losses are likely to fall as the degree of economic integration rises. The more closely integrated two economies are, the more likely that the shocks affecting one country will spillover into the other, and therefore a common policy response would be required. Also, the greater the regional mobility of labour the better, as following a shock, unemployed workers can simply migrate to areas with jobs. In this case, the costs of not being able to use a unique policy are diminished. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Costs: The LL Schedule • The LL schedule is a downward sloping function, which shows that the economic stability loss of joining a single currency falls with the degree of integration. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Currency Area or not? • The answer, as already alluded to, is simply to see whether the costs outweigh the benefits. • Where the GG and LL schedules intersect defines the critical level of integration: this is shown as X1. • If the joining country is more integrated than this level, X> X1, then the benefits from joining the single currency area outweigh the disadvantages. • Alternatively, at levels of integration below the critical level, X< X1, losses exceed gains. • An optimal currency area can therefore be thought of as a region or area where economies are closely linked by trade and have high factor mobility. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Currency Area Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Is Europe an Optimal Currency Area? • There is a high degree of trade integration between the member states of the European Union (EU). • Typically, most nations export between 10 to 20 percent of their output to other member countries. • On average the sum of intra-union exports and imports represents around 30% of GDP. • The extent of intra-European trade suggests there are substantial gains from monetary union. • The second reported efficiency gain would come from greater price competition, benefiting European consumers. Once all prices are quoted in the same currency, it should be easier for consumers to buy goods and services where they are cheapest. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Is Europe an Optimal Currency Area? • The main debate centres on the cost side. • The true costs of giving up control of monetary policy and an independent exchange rate will depend upon two factors. • First, how likely are asymmetric shocks? • Second, even if asymmetric shocks are a significant factor, will there be other adjustment mechanisms that a country can use? • These two considerations will determine the position of the LL schedule. If both are significant factors, then for every level of economic integration the stabilisation costs of a single currency will be higher and the LL schedule will shift upwards. As a result, the area is less likely to be an OCA, even with a relatively high level of economic integration. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Position of LL Schedule Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Is Europe an Optimal Currency Area? • Therefore, much of the debate on whether or not Europe is an OCA lies in the likelihood of different shocks, or a lack of flexibility, to deal with them. • Asymmetric Shocks: The euro area would actually be expected to be less prone to asymmetric shocks than the regions of the U.S. The euro area is a group of sovereign nations, each with a well-diversified production sector. The U.S., however, has been a single market for a considerable period of time during which a more acute degree of regional specialisation has occurred. • Blanchard and Wolfers (2000) do not find much evidence that one country will be subject to an asymmetric shock. Instead, it is argued that all nations face roughly the same shocks, but differences in labour market institutions propagate these shocks differently, creating different effects on unemployment. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Correction Mechanisms: Flexibility • Asymmetric shocks are not a problem so long as there is sufficient flexibility to deal with them if and when they occur. • Wage and Price Flexibility • Using the Mundell-Fleming model, we can see why high wage and price flexibility may be important in the EMU. In a monetary union, there is perfect capital mobility and a common interest rate. Because there is no independent monetary policy, there is no LM curve. Equilibrium is where the horizontal BP curve intersects the ISXM schedule at the full employment level of output. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Negative AD Shock: Mundell Fleming Model Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Correction Mechanisms: Flexibility • Suppose a country suffers a negative aggregate demand shock, as a result the ISXM curve shifts inwards and the equilibrium level of output falls below the full employment level. This would put downward pressure on wages and prices, which would improve competitiveness and lead to an improvement in output. Eventually, it is the adjustment of prices and wages that restores output to the full employment level. • However, the speed at which this happens is crucial, and obviously depends on the flexibility of labour and goods markets. If these are inflexible, then correction will be very slow implying that a shock can have long-lasting effects on output. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Index of labour market flexibility Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Overall Product Market Regulation Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Correction Mechanisms: Flexibility • It is obviously clear that the EMU member countries tend to perform very badly on this scale, especially in comparison to the U.S. which is deemed to have a very flexible labour market. • In terms of overall product market regulation is reported, the same conclusions are reached. The higher value of the index implies a higher level of regulation, and an expected lower level of flexibility. • It is again clear that EMU member states perform relatively badly, which raises fears of inadequate flexibility. • Low nominal flexibility increases the stability costs associated with a joining a monetary union. The would shift outwards, so even at high levels of integration, the EU may fail to be an optimal currency area. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Correction Mechanisms: Flexibility • Factor Mobility • Even if wage and price flexibility are poor, problems can be mitigated if the mobility of the factors of production, and in particular labour, is high. In this case, unemployed workers in one region can migrate to another in search of employment. • It is clear that mobility in EU countries is substantially lower than in Japan and the USA. People changing region of residence in 1986 (% of total population) France Germany Italy Japan UK U.S. 1.1 1.3 1.1 0.6 Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning 2.6 3.0 Fiscal Policy • An obvious solution to an asymmetric shock would simply be to launch an offsetting expansive fiscal policy. • Under monetary unions, and as is the case with EMU, all national governments retain control of fiscal policy to some extent, so surely it can be used to correct any shocks? • This is true in theory, and fiscal policy is an important correction mechanism in the USA. However, under the auspices of EMU, policy makers face strong constraints on their ability to use fiscal policy which will obviously hinder its ability to act as a correcting mechanism. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • Part of the EMU treaty is the Stability and Growth Pact (SGP). This requires government deficits to not exceed 3% of GDP, and the total national debt not to exceed 60% of GDP. Repeated failure to comply could result in a fine of up to 0.5% of GDP. • The rationale behind the SGP is due to the fear that under a monetary union, there is an incentive for fiscal indiscipline which can interfere in the efficient operation of monetary policy. • In a monetary union, there is only one interest rate. All government bonds, wherever they are issued are denominated in euros and there is one euro interest rate. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • If one nation runs an unsustainable debt, its risk premium will be spread over the bonds issued by the n members of the single currency, which would put upward pressure on the union interest rate. • As the effects of a fiscal expansion will be localised in the country it was undertaken whereas the interest rate effects will be shared around the union, there is an incentive to run excessive deficits. • Panel (a) describes the country undertaking the expansionary fiscal policy. Panel (b) shows the effects on other EMU members. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Expansionary fiscal policy in EMU Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • A counter argument to the SGP is that financial markets should be efficient and sophisticated enough to deal with the excessive deficits problem. • If one country is running large deficits, then the interest rate penalty should only apply to the bonds that the country issues. Even though there is only one euro interest rate, the risk premium on top of this could still vary from country to country. • In panel (a), a nation financing an expansive fiscal policy by borrowing will see financial markets impose a risk premium on its bonds. The rest of EMU, though, will be exempt from this risk premium. So, as panel (b) shows, it will be insulated from the effects of one nation’s excessive deficits. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Expansionary fiscal policy in EMU: Localised Effects Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • Proponents of the SGP do not believe this to be the case because of bailouts. If one nation defaults on its debts, the ensuing financial crisis will spillover on the rest of Europe. • If one country defaults, then creditors in other countries will lose out. This may lead them in turn to default on other loans, or require the immediate liquidation of other assets, with repercussions, such as a general banking collapse. The effects on union output could be substantial and widespread. • For that reason, the logical action would be for the other countries in the EMU to bail out the deficit nation. In this way, the interest rate risk premium cannot be limited to just one nation, it will be a problem shared by all. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • Part of the EMU constitution is the “no bail out clause.” This suggests that if a country where to be in serious debt problems, the other countries in EMU will not bail it out. • The problem with this clause, though, is that it does not constitute a credible policy ex post. • If one country were to risk default, the optimal policy would be to try and mitigate the effects of a financial crisis, which could involve bail out. • If financial markets accept this to be the only time consistent policy (hence, the no bail out clause is time inconsistent), then the rest of the euro area cannot isolate itself from the excessive deficits of one nation. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • Fiscal policy in EMU suffers from two conflicting concerns – the need for flexibility to deal with shocks, and also the need to deal with the potential problems of excessive deficits. The SGP is a very contentious part of EMU, and a large body of opinion would argue that it is unbalanced in these objectives. The requirements of the SGP are argued to be too rigid. • Government deficits are likely to be cyclical due to automatic stabilisers. In a recession, the government budget moves towards deficit, meaning that fiscal policy becomes most constrained at precisely the point it is most needed. • The SGP, therefore, imposes a heavy deflationary burden on Europe because policy must tighten in times of low growth. The growth record of the EU is seen next. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning U.S. vs. EU-11 Growth (%) Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Fiscal Policy • The operation of fiscal policy in the U.S. is much more geared to the correction of asymmetric shocks. • Due to its federal structure, the government can redistribute income to states that are subject to negative shocks. • It is often argued that a successful monetary union will require some form of fiscal federalism. • Given that deficits are cyclical, this would involve transfers from surplus (high growth) to debtor (low growth) countries. • In this way, the effects of unsynchronised business cycles or asymmetric shocks can be smoothed. Whether or not fiscal federalism is politically workable in the euro area though is a separate question. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Should the UK join the Euro? • The theory of optimal currency areas plays a central role in the debate as to whether or not the UK should join the EMU. • Specifically, the basis of this assessment comes down to whether the UK is adequately converged with the rest of EMU, and that it has sufficient flexibility to deal with asymmetric shocks. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Should the UK join the Euro? • For a single monetary policy to be universally appropriate, it must be the case that economies have achieved an adequate degree of convergence. • There are two strands to the convergence issue: convergence in cycles and convergence in structures. • Adopting a single currency implies the sacrificing of monetary policy autonomy. Exchange rates disappear, and an one-size-fits-all interest rate is applied across the entire monetary union. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Should the UK join the Euro? • Convergence in cycles refers to the synchronisation of business cycles. An one-size-fits-all interest rate will be problematic if different countries are in different stages of the economic cycle. A nation experiencing slow growth would require a loosening of policy, whereas those growing strongly might require higher rates to control inflation. Under these conditions, it would be impossible for one monetary policy to satisfy the differing needs of each economy simultaneously. • It appears to be the case that historically the UK business cycle is more strongly correlated with the U.S. than the Euro area. As such, European levels of interest rates may be inappropriate for the UK economy. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Should the UK join the Euro? • There appears to be sufficient evidence to conclude that the UK and Euro-11 business cycles are not sufficiently convergent. However, even if an adequate degree of cyclical convergence is achieved, the convergence test can still subject to failure because there would be significant structural differences between the UK and the rest of EMU to make the possibility of future asymmetric shocks a major cause for concern. • Convergence in structures relates to the idea that economies may have structural differences that will make a common monetary policy infeasible. Different economies could be subject to different shocks, or react in different ways to the same shocks, or have different monetary policy transmission mechanisms. In this case, the common monetary policy itself can be the cause of asymmetric shocks. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Should the UK join the Euro? • Empirical evidence indicates that the monetary policy transmission mechanism is much stronger in the UK than the rest of Europe due to the structure of its housing market. • The two most important are the relatively high proportion of owner occupied hosing in the UK, and also the high proportion that hold flexible rate mortgages. • Interest rate changes will have a much more profound effect on UK aggregate demand than in the rest of Europe because mortgage debt represents a relatively large proportion of GDP. • This almost certainly means that even if the UK achieves convergence in cycles with the rest of Europe, it would still stand to strongly benefit by maintaining autonomy over monetary policy. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Should the UK join the Euro? • Flexibility • The UK exhibits higher nominal flexibility than Europe. This would imply that the UK is relatively well positioned to adjust to asymmetric shocks. However, this may be a problem as the UK’s flexibility does not appear to be mirrored in the major EMU member states. • Work by Blanchard and Wolfers (2000) argues that differences in unemployment are not accounted for by asymmetric shocks, but by asymmetric responses to common or symmetric shocks because of differences in labour market institutions. For example, if a common negative shock hit all of Europe, then unemployment will rise. Therefore, the UK will find itself in a position where it requires less of a stimulus than other EMU states in order to reinstall full employment. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning The Dynamic Nature of Optimal Currency Areas • A valid criticism of the OCA theory and evidence presented so far is that it is very static. In assessing entry to a monetary union, it is also necessary to consider the dynamics that might result from the entry decision. A simple way of analysing this was devised by Frankel who derived the OCA line. • Countries that are highly integrated and have high-income correlations are more likely to successfully develop and maintain an OCA. Strong trade links increase the monetary benefits of a single currency, whereas high correlation of incomes represents convergence and lower stability losses. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning OCA Line Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning The Dynamic Nature of Optimal Currency Areas • The OCA line essentially compares the costs and benefits of adopting a single currency. However, these may change over time, especially once a monetary union has been established and a single currency adopted. • Once a single currency has been established, the nature of trade and income convergence might change. Almost certainly, a single currency will increase the extent of trade among the members of the single currency as transactions costs are reduced. Whether or not this makes an OCA more or less likely depends on the effect increasing openness has on income correlation. • One view by McCallum is that increasing openness leads to more significant spillovers between countries and therefore a higher degree of income correlation. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Endogeneity of OCAs dominate Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning The Dynamic Nature of Optimal Currency Areas • However, an alternative hypothesis pushed by Krugman is known as the specialisation hypothesis. • Increasing trade leads to increasing specialisation as nations seek to capture the welfare benefits associated with comparative advantage. • A more specialised industrial sector will in turn reduce the correlation of income and increase the possibility of asymmetric shocks. • In this case, the dynamics of an OCA will eventually lead to its own failure. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Endogeneity of OCA fails Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary • We investigated three topics as to how policy makers manage the international aspects of their economy. These are the type of exchange rate regime, international policy coordination, and monetary union. Over the last twenty five years, these have been important considerations for most developed nations. • We looked at the two types of exchange rate regimes, fixed and floating, and their respective advantages and disadvantages. The choice of regime has been an ongoing issue for the past century. • We also considered the subject of international policy coordination in terms of transmission of shocks and the impact of global demand. The role of the U.S. in the global economy was analysed. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary • Finally, we covered optimal currency areas (OCA). With the recent development of European Monetary Union (EMU) and the establishment of a single currency in Europe (the euro), this has been important. • We examined several outstanding issues for OCAs, including the single market in Europe and whether the UK should adopt the euro. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning