Download Costs and Benefits (% GDP)

Monetary integration
José Villaverde Castro
Universidad de Cantabria
This slides are based on the book “Economics of Monetary
Union”, by P. De Grauwe. OUP.
Outline of the presentation
– Degrees of economic integration
– Concept of a monetary union
– The costs of a monetary union
– The benefits of a monetary union
– Costs and benefits compared
Degrees of economic integration
Common No
Free
No visible external
invisible
mobility of
trade
trade
trade
factors and Common
restrictions restrictions restrictions assets
currency
Free trade area
X
Custom union
X
X
Internal commodity market
X
X
X
Common market
X
X
X
X
Monetary union
X
X
X
X
X
Economic union
X
X
X
X
X
Common
economic
policy
X
Concept of a monetary union
– Common currency
– Common central bank
The costs of a common currency
• Costs arise because, when joining a
monetary union, a country looses policy
instrument: monetary policy (e.g.
exchange rate, interest rate)
• This is costly when asymmetric shocks
occur
• Sources of asymmetry:
– Shifts in demand
– Different preferences between inflation and unemployment
Shifts in demand (Mundell)
• Assume two countries, France and Germany
• Asymmetric shock in demand
– Need to distinguish between permanent
temporary shock
– Decline in aggregate demand in France
– Increase in aggregate demand in Germany
• We will analyze this shock in two regimes
– Monetary union
– Monetary independence
and
Aggregate demand and supply in France and Germany
France
PF
Germany
P
SF
SG
G
DF
YF
DG
Y
G
First regime: monetary union
• How can France and Germany deal with this
shock if they form a monetary union?
• Thus France cannot stimulate demand using
monetary policy; nor can Germany restrict
aggregate demand using monetary policy
• Do there exist alternative adjustment
mechanisms in monetary union?
– Wage flexibility
– Labour mobility
The automatic adjustment process (Wage flexibility)
France
Germany
PF
P
G
YF
Y
G
Second regime: Monetary independence
France
PF
Germany
P
SF
SG
G
DF
YF
DG
Y
G
Conclusion
• Thus, when asymmetric shocks occur
• And when there are a lot of rigidities
• Monetary union may be more costly
than monetary independence
• What about fiscal policies? (income
transfers between countries or between
generations)
Fiscal policy
Automatic stabilisers: Centralised budget or
decentralised budget
• Centralised budget allows for automatic transfers
between countries of the monetary union
• Decentralised: flexible national budgets
– France allows deficit to accumulate; Germany
allows surplus
– This imples automatic transfers between
generations within the same countries
– Create problems of debt accumulation and
sustainability
Other sources of asymmetry (In the
response to shocks)
• Different labour market institutions (supply
shocks): Centralized versus non-centralized wage
bargaining.
• Different financial systems
• Different growth rates
• Different fiscal systems:
Goverment
constraint: (G-T-rB= dB/dt + dM/dt)
budget
Symetric shocks in a monetary union
France
Germany
PF
P
G
YF
Y
G
The benefits of a common currency
• The costs of EMU have mostly to do
with macroeconomic management
• The benefits are mostly microeconomic
in nature: they arise from efficiency
gains
Sources of benefits
• Less transactions costs: Direct and Indirect
effects (Price transparency)
• Less uncertainty: No exchange rate risk
• 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)
Price transparency
• One common unit of account facilitates
price comparisons: Consumers “shop
around” more.
• Competition increases.
• Prices decline and consumers gain.
Less exchange risk
• Euro eliminates exchange risk. Less
uncertainty. Increase welfare
– Does the decline in exchange risk increase
welfare?
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 monetary
union are likely to be
larger for relatively open
economies
Benefits
(% of GDP)
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
Trade (% of GDP)
The cost of a monetary union and the
openness of a country
Cost
(% of GDP)
•Countries that are very
open experience less costs
of joining a monetary union
compared to relatively
closed economies
•The reason is that
relatively open economies
loose an instument of
policy that is relatively
ineffective, and are more
resilient
Trade (% of GDP
Costs and Benefits (% GDP)
Costs and benefits of a monetary union
Benefits
Costs
Trade (% GDP)
Two views about costs and benefits
of MU
(a) The monetarist view
Benefits
Costs and benefits
Costs and benefits
Benefits
(b) The Keynesian view
Costs
Costs
T*
T*
Trade (% GDP)
Trade (%GDP)
Two views about costs of MU
• The 'monetarist‘ view :
– Monetary policies are ineffective as
instruments to correct for different
developments between countries.
– The cost curve is close to the origin.
– Thus, many countries in the world would
gain by relinquishing their national
currencies, and by joining a monetary
union.
• The 'Keynesian' view :
– the world is full of rigidities
– Monetary policy (including exchange rate
policy) is a powerful instrument in
eliminating disequilibria
– the cost curve is far away from the origin
– relatively few countries should find it in
their interest to join a monetary union
Costs and benefits
Costs and benefits with decreasing
rigidities
Benefits
With decline in wage and
price rigidities and an
increase in labour mobility:
Cost curve shifts
downwards
Monetary union becomes
more attractive
Costs
T*
T**
Trade (% GDP)