Title: Chapter 2: The Theory of Optimum Currency Areas: A Critique
1Chapter 2The Theory of Optimum Currency Areas
A Critique
- De Grauwe
- Economics of Monetary Union
2- Critique of OCA-theory can be formulated at three
different levels - How relevant are the differences between
countries? Should we worry? - Is national monetary policy (including exchange
rate policy) effective? - How credible are national monetary policies?
3How relevant are the differences between
countries?
- Should we worry?
- Lets analyze these differences
41. How likely are asymmetric demand shocks when
integration increases?
- There exist two views
- Optimistic view
- intra-industry trade leads to similar
specialization patterns - Integration leads to more equal economic
structures and less asymmetric shocks - Pessimistic view
- economies of scale lead to agglomeration effects
and clustering - Integration leads to more asymmetric shocks
5Figure 2.1 Optimistic view
symmetry
Trade integration
6Figure 2.2 Pessimistic view
symmetry
Trade integration
7- Which view is likely to prevail?
- A little bit of both
- But even if pessimistic view prevails,
agglomeration effect will be blind to national
borders - Then asymmetric shocks cannot be dealt with by
national monetary policies - Empirical evidence of Frankel and Rose favours
optimistic view - Role of services they are increasingly
important, and less subject to economies of scale
82. Institutional differences in the labour market
- Institutional differences in labour markets
create asymmetries in the transmission of shocks - Some of these differences disappear in the
monetary union - Monetary union puts pressure on trade unions
- Other differences will remain in place
93. Different legal systems and financial markets
- The reduction of inflation differentials in
monetary union leads to institutional convergence - e.g. maturity structure in bond markets converges
- However, not all institutional differences will
disappear - Legal systems remain very different creating
deep differences in financial systems - Cfr. Difference between Anglo-Saxon and
Continental European financing of firms
104. Asymmetric shocks and the nation-state
- Existence of nation-states is a source of
asymmetric shocks - Taxation and spending remains in realm of
national sovereignty - Social policies are national
- Wage policies
- This creates a need for further political
integration in a monetary union
11Recent divergencies in the Eurozone
Wage policies in Germany Since 2000 declining
nominal growth of wages in Germany Induced by the
need to restore previous losses of
competitiveness And a desire to face competition
from low wage countries Germany improved its
competitive position vis a vis the rest of the
Eurozone Note also contrast with US and UK
12Dramatic effect on competitive positions within
the Eurozone
Index is based on ULC (takes into account
productivity differentials) Germany improves its
competitive position At the expense of many
other Eurozone countries
135. Do differences in growth rates matter?
- Countries with low level of development and high
economic growth will not be constrained in
monetary union - Capital market integration may give a boost to
the growth in countries with low level of
development
14- How effective are national monetary policies?
15 - The question we analyse here is whether national
monetary policies are effective instruments to
correct for asymmetric disturbances. - Two disturbances are analyzed
- Permanent asymmetric demand shock
- Temporary asymmetric demand shock
16Permanent asymmetric demand shocks
- These were analysed in the previous chapter
- These require a change in relative prices
- Such a relative price change cannot be achieved
by monetary policies
17Figure 2.7 Price and cost effects of a national
monetary policy
PF
After monetary expansion real wage
declines Workers will want to be compensated by
higher nominal wage Supply shifts upwards thereby
reducing output effect of monetary
expansion Effectiveness of monetary policy is
reduced It does not make a difference whether
country is in MU
SF(W2)
SF(W1)
F
F
DF
DF
YF
18However
- Monetary expansion can, however, sometimes make
the dynamics towards new equilibrium less costly
than alternative policy strategies. - The latter is typically more deflationary and
leads to larger output losses
19Adjustment through deflation
Adjustment through monetary expansion
P
P
Y
Y
20National monetary policies to stabilize for
temporary asymmetric demand shocks
- Many demand shocks are temporary. For example,
business cycle shocks - These business cycle shocks can be asymmetric
- The issue that arises here is one of
macroeconomic stabilization. Let us return to
figure 1.1 of the previous chapter
21Figure 1.1 Aggregate demand and supply in France
and Germany
France
Germany
PF
SG
PG
SF
DG
DF
YG
YF
22- We now interpret this figure as representing
completely asynchronous business cycle shocks - i.e. when there is a recession in France there is
a boom in Germany. In the next period, it will
then be the other way around with a boom in
France and a recession in Germany.
23- If these two countries form a monetary union they
have a problem The common central bank is
paralysed - If it lowers the interest rate to alleviate the
French problem, it will increase inflationary
pressures in Germany - If it raises the interest rate to counter the
inflationary pressures in Germany it will
intensify the recession in France
24- Since the shocks are temporary wage flexibility
and mobility of labour cannot be invoked to solve
this problem - In a monetary union there is simply no solution
to this problem the common central bank cannot
stabilize output at the country level it can
only do this at the union level
25- When France and Germany, however, keep their own
money they have the tools to stabilize output at
the national level - Thus when France is hit be a recession the French
central bank can stimulate aggregate demand by
reducing the interest rate and allowing the
French Franc to depreciate - Similarly, when Germany experiences a boom, its
central bank can raise the interest rate and
allow the currency to appreciate to dampen the
boom
26- In a monetary union these countries loose their
ability to do so - The question that arises here is how effective
these stabilization policies are at the national
level - We postpone the discussion here, and we will
return to it later - There we will show that sometimes too active a
use of monetary stabilization can lead to new
sources of instability
27Currency depreciations to correct for different
policy preferences
- In Keynesian world exchange rate adjustment allow
countries to select desired point on
inflation-unemployment trade-off. - Not so in monetarist world where long-run
Phillips curve is vertical
28Figure 2.7 Monetary Union in a world of vertical
Phillips Curves
Germany
0
Italy
0
29An aside Productivity and inflation in monetary
unionThe Balassa-Samuelson effect
- Inflation differentials in monetary union can be
significant
Average yearly inflation in Eurozone countries,
1999-2005 ()
30Balassa-Samuelson model
- Inflation in France
- Inflation in Ireland
- (we assume that inflation in non-tradables is
equal to wage inflation) - Inflation rates in tradable goods sectors are
equal -
- This leads to
- Assuming that differences in wage increases
reflect differences in productivity growth we
obtain - Inflation in Ireland exceeds inflation in France
if Irish productivity increases faster than
French productivity
31Should wage bargaining be centralized in monetary
union?
- This implies that if productivity growth is
higher in Ireland than in France, wages should
increase faster in Ireland than in France - If centralized wage bargaining leads to equal
wage increases, France looses competitiveness
32National monetary policies, time consistency and
credibility
33- Credibility affects the effectiveness of policies
- We use Barro-Gordon model
- We first develop closed-economy version
- Then we develop two-country version
34Barro-Gordon model
- There is a short-term trade-off between inflation
and unemployment for every level of expected
inflation - The vertical line represents the 'long-term'
vertical Phillips curve. It is the collection of
all points for which - This vertical line defines the natural rate of
unemployment UN
35Figure 2.12 The preferences of the authorities
- Indifference curves are concave
- Slope expresses relative importance attached to
fighting inflation versus fighting unemployment
I3
I2
I1
U
36Figure 2.13 The preferences of the authorities
Hard-nosed government
Wet government
I3
I2
I3
I1
I2
I1
U
U
- Hard-nosed government attaches a lot of weight
to fighting inflation
- Wet government attaches a lot of weight to
fighting unemployment
37Figure 2.14 The equilibrium inflation rate
- Announcing a zero inflation policy is not
credible because authorities prefer point B to A - Rational agents know this
- Therefore they will set their expectations about
inflation such that authorities have no incentive
anymore from the announced inflation rate - This is achieved in point E, which is the
rational expectations time consistent equilibrium
E
C
B
A
U
UN
38Figure 2.15 Equilibrium with hard-nosed and
wet governments
Hard-nosed government
Wet government
E
E
B
B
A
A
U
UN
U
UN
- Hard-nosed government achieves lower inflation
equilibrium than wet government without
imposing more unemployment in the long run
39Figure 2.16 Equilibrium and the level of natural
unemployment
Equilibrium inflation rate also depends on the
level of the natural unemployment
E
E
B
A
U
UN
UN
40The Barro-Gordon model in an open economy
- We add the purchasing power parity condition to
link the inflation rates of two countries, called
Germany and Italy, i.e. -
41How can Italy reach a more attractive (lower)
inflation equilibrium?
Germany
Italy
E
G
C
F
A
UG
UI
Fixing the exchange rate of the lira with the
mark is not credible, because Italian authorities
have an incentive to create surprise inflation
(devaluation)
42- Only by abolishing the Italian central bank and
adopting the mark can Italy escape from high
inflation equilibrium - This is also what countries that decide to
dollarize hope to achieve - Monetary union is more complicated because in
monetary union both central banks decide jointly
and a new currency is created - This leads to problem in that new central bank
may not have the same reputation as the German
Bundesbank - The latter is reluctant to join
43Optimal stabilisation and monetary union
Figure 2.18 Optimal stabilization in country
with high preference for unemployment stability
- Dotted line is optimal stabilisation line
- Without stabilisation unemployment would
increase to B after shock - With stabilisation increase in unemployment is
limited to B - The price paid is higher inflation
- Price increases with steepness of stabilisation
line
44Figure 2.19 Optimal stabilization in country
with low preference for unemployment stability
- This country cares less about unemployment
- Same shock will lead to stronger increase in
unemployment - But less inflation
45- When countries join a monetary union, they indeed
loose an instrument of policy that allows them to
better absorb temporary (asymmetric) shocks - However, this loss may not always be perceived
to be very costly because countries that actively
use such stabilization policies also pay a price
in terms of higher long-term rate of inflation
46Cost of monetary union and openness
Figure 2.20 Effectiveness of currency
depreciation as a function of openness
Very open country
PC
PO
Relatively closed country
SO
SC
DO
DC
YC
YO
47Figure 2.21 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 instrument of policy that is relatively
ineffective
Trade ( of GDP