Chapter 3: The Benefits of a Common Currency

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Chapter 3The Benefits of a Common Currency

• De Grauwe
• Economics of Monetary Union

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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

3
Sources of benefits

• Less transactions costs
• Price transparency
• Less uncertainty
• Benefits of an international currency
• Does monetary union lead to more economic growth?

4
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)

5
Price transparency

• One common unit of account facilitates price
  comparisons
• Consumers shop around more
• Competition increases
• Prices decline and consumers gain

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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

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Eurozone has not increased price convergence
Figure 3.1 Evolution of price dispersion in the
Eurozone, 19902005

• 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

SourceWolszczak-Derlacz (2006)
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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

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• 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

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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?

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Less exchange risk and welfare

• Take individual firm under perfect competition

Price certainty
Price uncertainty
P
P
MC
MC
F
E
P3
G
B
P1
P1
P2
C
q
q
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• 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

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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

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Monetary Union and economic growth

• Neo-classical growth model

y
r
f(k)
A
r
k
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Potential growth effects of monetary union

• MU eliminates exchange risk and may reduce
  systemic risk. If so, real interest rate declines
• rr-line becomes flatter (rr)
• Economy moves from A to B
• Per capita income increases because of capital
  accumulation
• Economic growth increases during transition from
  A to B

y
r
r
f(k)
B
A
r
r
k
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Endogenous growth and monetary union
y
C
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)
B
A
k
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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)

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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

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Benefits of monetary union and openness
Benefits ( 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

Trade ( of GDP)
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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
yU
yL
yL
yU
y
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Shocks in LM-curve Monetary union reduces
variability of output
LML
r
LM
LMU
G
rf
ISU
IS
ISL
yU
yL
y
y