The Benefits of a Common Currency

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The Benefits of a Common Currency
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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

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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

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

• 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

Source Engel and Rogers (2004)
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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 uncertainty
Price certainty
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 firm can
  go bankrupt model assumes no bankrupcy 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
Capital accumulation can lead to dynamic effects
leading to technological innovations. Production
function f(k) then shifts outwards raising
economic growth
y
C
f(k)
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.
• 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