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Chapter 3:
The Benefits of a
Common Currency
De Grauwe:
Economics of Monetary Union
Introduction
• The costs of EMU have mostly to do with
macroeconomic management
• The benefits are mostly microeconomic in
nature
– i.e. they arise from efficiency gains of a monetary
union
Sources of benefits
•
•
•
•
•
Less transactions costs
Price transparency
Less uncertainty
Benefits of an international currency
Does monetary union lead to more economic
growth?
Less transactions costs
• Elimination of foreign exchange markets
within union eliminates cost of exchanging
one currency into another
• Cost reductions amount to 0.25 to 0.5% of
GDP (according to European Commission)
• Full cost reduction only achieved when
payments systems are fully integrated
– TARGET payment system
– New initiatives to create a Single Euro Payments
Area (SEPA)
Price transparency
• One common unit of account facilitates price
comparisons
• Consumers “shop around” more
• Competition increases
• Prices decline and consumers gain
Will euro increase price transparency
in a significant way?
• Large price differentials continue to exist
• These have to do with
– transactions costs at the retail level
– and product differentiation
• See next tables
Table 3.1: Relative difference in intra- and inter-country price dispersion for selected products
(excluding VAT), 2000
Dispersion across
Average dispersion
Countries
inside countries
(inter-country)
(intra-country)
Supermarket products
EVIAN MINERAL WATER
REXONA DEODORANT
SENSODYNE TOOTHPASTE
MARS BARS (SINGLE)
MARS BARS (MULTIPACK)
COCA COLA
PEDIGREE PAL DOG FOOD
PLENITUDE FACE CARE
COLGATE TOOTHPASTE
BONNE MAMAN MARMELADE
43%
21%
21%
21%
22%
21%
10%
21%
14%
19%
4%
2%
2%
2%
3%
4%
2%
5%
4%
6%
Table 3.1: Relative difference in intra- and inter-country price dispersion for selected products
(excluding VAT), 2000
Dispersion across
Average dispersion
Countries
inside countries
(inter-country)
(intra-country)
Electronic products
PHILIPS AUDIO SYSTEM
28%
20%
SONY AUDIO SYSTEM
38%
25%
CANON CAMCORDER
32%
6%
PANASONIC PORTABLE CD
40%
11%
PHILIPS PORTABLE CD
56%
20%
PIONEER CD PLAYER
34%
12%
SONY CD PLAYER
28%
12%
PHILLIPS TV (14 inch)
41%
22%
SONY TV (14 inch)
33%
19%
PANASONIC TV (28 inch)
25%
24%
PHILIPS TV (28 inch)
61%
49%
JVC VCR
30%
16%
PANASONIC VCR
22%
26%
SONY VCR
44%
25%
Source: European Commission, Price dispersion in the internal market, and Price differentials for
supermarket goods in the EU. Both documents can be downloaded from www.europa.eu.int
Eurozone has not increased
price convergence
Figure 3.1: Evolution of price dispersion in the Eurozone, 1990–2005
0,45
• Euro has not changed
this
• There is no evidence of
price convergence
• Euro may work
indirectly by triggering
further market integration
in particular sectors, e.g.
banking, insurance
mean standard deviation
0,4
0,35
0,3
0,25
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Source:Wolszczak-Derlacz (2006)
The introduction of the Euro and
perceived price increases
• A major surprise about the introduction of the
Euro is its unpopularity in a number of
Southern countries
• Especially in Italy, but also in Greece, the
introduction of the Euro is associated with
massive price increases
Table 1: Price increases of food products (from Nov 2001 to Nov 2002)
Breakfast (bread, snacks)
Pasta, bread, rice
Beverages
Meat, eggs and fresh fish
Cold cuts
Canned food
Fruit and vegetables
Frozen food
23,3%
20,1%
32,9%
22,1%
27,5%
30,9%
50,8%
23,6%
Total
29,2%
Possible explanation:
•Low budget items, with low price elasticities
•Competitive markets make it difficult to raise prices
•Introduction of Euro creates signal lowering the cost of collective
action
Less exchange risk
• Euro eliminates exchange risk. Two issues:
– Does the decline in exchange risk increase
welfare?
– Does the decline in exchange risk reduce
systemic risk?
Less exchange risk and welfare
• Take individual firm under perfect competition
Price certainty
Price uncertainty
P
P
MC
MC
F
E
P3
P1
G
B
P1
P2
q
C
q
• Profits are higher on average when there is
price uncertainty
• Welfare will then depend on degree of risk
aversion
• If risk aversion sufficiently high price certainty
is preferred by firms
• Model has a number of important
assumptions:
– No adjustment costs
– With sufficiently large price declines firms can go
bankrupt; model assumes no bankruptcy costs
Exchange rate uncertainty and the
price mechanism
• Large exchange variability reduces the quality
of price signals in allocating resources
• Example: large overvaluation of dollar in
1980s led to decline of export sector; a
decline that turned out to be unnecessary
once the dollar declined again
• These large real exchange rate cycles lead to
large adjustment costs
Monetary Union and
economic growth
• Neo-classical growth model
y
r
f(k)
A
r
k
Potential growth effects
of monetary union
y
r
B
r’
•MU eliminates exchange
risk and may reduce
systemic risk. If so, real
interest rate declines
•rr-line becomes flatter (r’r’)
•Economy moves from A to
B
•Per capita income
increases because of
capital accumulation
•Economic growth
increases during transition
from A to B
r’
f(k)
A
r
k
Endogenous growth
and monetary union
y
C
B
f’(k)
•Capital accumulation can
lead to dynamic effects
leading to technological
innovations.
•Production function f(k)
then shifts outwards
raising economic growth
f(k)
A
k
Empirical evidence about monetary
union and growth
• First generation empirical studies found little
relation between exchange rate volatility, trade
and investment
• Using cross-section evidence Andy Rose recently
found strong effect of monetary union on trade:
– A monetary union doubles trade among members
of union, on average
– More recent econometric evidence has reduced
these effects to 10%-20%
• The link monetary union-trade then has positive
effect on per capita income (Frankel and Rose)
Benefits of an
international currency
• International use of the dollar creates
seigniorage gains for the US
• Similarly, if Euro becomes an international
currency, seigniorage gains will follow for
Euroland
• These gains, however, remain relatively
small:
– in the case of the US: less than 0.5% of GDP per
year
Benefits of monetary union
and openness
Benefits
(% of GDP)
Trade (% of GDP)
•Benefits of monetary
union are likely to be
larger for relatively open
economies
•In absence of monetary
union, transactions costs
and exchange risk are
larger for firms in very
open economies
•Monetary union will be
more beneficial for firms in
very open economies
•Upward sloping benefit
line
Box 5: Fixing exchange rate
and systemic risks
Shocks in IS-curve:
Monetary union increases variability of output
r
LM
F
rf
ISU
IS
ISL
yL
y’L
y’U
yU
y
Shocks in LM-curve
Monetary union reduces variability of output
LML
r
LM
LMU
G
rf
ISU
IS
ISL
yL
y
yU
y