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OPTIMAL CURRENCY AREA II WEEK 3 Chapter 2 and 3 Chapter 4 (reading) Lecture plan 1. Analysing monetary union costs: how effective are national macroconomic policies? – PowerPoint PPT presentation

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  • WEEK 3
  • Chapter 2 and 3
  • Chapter 4 (reading)

Lecture plan
  • 1. Analysing monetary union costs how effective
    are national macroconomic policies?
  • 2. The benefits of a single currency

The effectiviness of national macroeconomic
  • Monetary and exchange rate policiesjob is to
    offset shocks
  • a) permanent
  • b) temporary
  • Monetary policy (decrease in i, and subsequent
    decrease in E under flexible exchange rate
  • Exchange rate policy (decrease in E under fixed
    exchange rate regime)

Permanent shock
  • Permanent shift in demand from French to German
  • If France doesnt want (or is not in the
    position) to wait for the necessary supply
    adjustment to occur, then it can implement
    expansionary monetary/exchange rate policy to
    shift back AD curve.
  • Devaluation raises imports prices, and shifts AS
    curve leftward (even further away if wage-setting
    process is such that)

  • In the long-run, expansionary policy will not
    restore the original equilibrium
  • Once again, we notice that the devil lies in
    the aggregate supply dynamics through the labour
  • Devaluation drug.
  • What would be the situation in a monetary union?
  • In both cases, after a permanent demand shock,
    France has to be willing to accept a decline in
    the real wage (either through AS rightward shift,
    or devaluation)
  • Maybe it can be more politically sustainable, but
    economically speaking it all comes down to that.

Temporary shock the Barro-Gordon model
  • When we face a temporary shock, we are in the
    classic macroeconomic situation (stabilization
  • Here we have a classic anti-euro argument if
    France is hit negatively and Germany positively,
    under a monetary union ECB should do nothing (the
    two shocks offset each other)
  • Instead, under national macroeconomic policies,
    each country can best pursue its own
    stabilization policy.
  • How effective are these national stabilization

Barro-Gordon in words
  • Before Barro-Gordon a country can choose its
    most preferred combination on the
    inflation-unemployment frontier
  • Do you wanna have less unemployment.? You just
    have to bear some more inflation (brought about
    by AD shifts, due to macroeconomic policies).
  • The crucial role of expectations expectations
    matter. High inflation today means that people
    will expect high inflation tomorrow, and this
    will actually bring about more inflation

  • Phillips curve (negative relationship between
    inflation and unemployment) is not stable.
  • Whatever increases inflation expectations moves
    Phillips curve upward
  • And what would that be? Inflation!
  • If I push aggregate demand up today, I will
    absorb more inflation at the expense of more
  • But this additional inflation wont stop
    here..it will increase inflation expectations
    for tomorrow, and this will actually increase
    inflation tomorrow, even if unemployment does not
  • There is an independent (not unemployment)
    reason why inflation can raise..inflation

  • In the long-run there is no trade-off to be
    exploited between inflation and
    unemployment..sooner or later, you will find
    yourself on a vertical line (long-run Phillips
  • So its not true that a country (outside a
    monetary union) is free to choose its most
    preferred combination. Unemployment equilibrium
    level is pinned down by the natural level
    (potential leve ) of output
  • In the long-run.
  • .maybe we can still rely on the short-run?
  • (skip 2.4, well save it for later)

  • Monetary policy is useless if used in a
    discretionary way the more rational
    expectations are, the more useless monetary
    policy is.
  • The key is that the private sector is aware of
    monetary policys incentive to cheat, and act
  • The result of the process is that inflation rate
    will be higher than the one announced by central
  • How does it happen?

The process in steps
  • 1) CB announces ?0.
  • 2) Private sector knows that once they fix their
    nominal variables (w and p) based on CBs
    announcement, CB will have anyway the incentive
    to reduce unemployment at the expense of more
    inflation (surprise inflation). In that case,
    private sector will suffer of a reduction in
    purchasing power.
  • 3) Based on 2), private sector will increase
    their inflation expectations, and this will
    actually increase ? (Phillips curve shifts
  • 4) The process ends only on the vertical Phillips
    curve, where inflation expectations are met.

The hijacking
  • 1) A given country announces that in case of
    hijacking it will never negotiate.
  • 2) A hijacking does occur, with 200 hostages, and
    ask for a small ransom. Whats the optimal action
    by authorities? To give in, and save 200 lives.
  • 3) Knowing 2), terrorists around the world wont
    believe further announcements by government, and
    will be incentived to hijacking.

Whats the solution?
  • Never negotiate. Gain the necessary credibility
    so to curb any expectations by terrorist.
  • Be credible. Persuade the public that, no matter
    what, CB will never implement surprise
    inflation (i.e. it will never try to exploit the
    short-run trade off to reduce unemployment below
    the natural level).

So what are we saying?
  • 1) Inflation-unemployment trade off does not
    exist in the long-run, due to AS shifts (increase
    in production costs)
  • 2) Inflation-unemployment trade off might not
    even exists in the short-run, due to private
    sector expectations and lack of credibility by CB
    (private sector is aware of CBs incentive to
    deviate from zero inflation announcement, and
    thus update inflation expectations). As a result,
    inflation will be inefficiently higher.
  • A solution to 2), is to tie CBs hands make
    them independent from political power and

  • Bank of Italys divorce (1978)
  • Volcker (1979)
  • Bundesbank
  • Bank of New Zealand
  • Bank of England (1997)
  • ECB (1999)
  • All round the world, CB realized that
    establishing a sound reputation of credibility
    (I will stick to my inflation goal and wont try
    to cheat once inflation expectations are

In open economy
  • Proceeding with out initial analogy, just replace
    inflation rate target with exchange rate
  • CB can exploit the trade-off by creating surprise
    inflation (by pursuing expansionary monetary
  • as well as
  • creating surprise devaluation
  • In both cases were talking about expansionary
    macro policies that wont accept the natural
    level of output and try to push the economy above

  • Do you mean that if an economy is featured by
    low potential output growth it should just learn
    to live with it?
  • No.
  • Just solve the problem with adequate means.
  • Raise the potential growth (non-inflationary
  • Total factor productivity (RD, human capital,
    innovation,technology, social and economic
    infrastructure, stability, protection of property
    rights.whatever helps capital and labour do
    their job)
  • Increase in labour force (participation in the
    labour market).

  • If you cant do that (because its too hard
    and/or it takes too long), you are surely tempted
    to raise output growth simply by injecting
    drugsExpansionary monetary/exchange policy
  • But this wont bring you any benefits in the
    long-run (output goes back to its natural level
    with higher prices), and not even in the
    short-run (price setting by private sector will
    take into account CB opportunistic behaviour).
  • Economics has never historically agreed on the
    speed of the latter process (monetarists it
    happens instantaneously. Keynesians it happens
    very slow because of nominal variables
  • But they agree on the fact that it does happen,
    sooner or later.

  • So we found out that macroeconomic policies need
    to be handled carefully.
  • If they are used to push output above potential,
    they are damaging. So in this respect, countries
    forming a monetary union loose a dangerous
  • But we still have a powerful argument to
    fightwhat if they are used against shocks?
    Would then be a more significant loss?

CB reaction to supply shock
  • When a supply shock occurs, Phillips curve shifts
    rightward (i.e. more inflation for any given
    level of output).
  • Then we face the macroeconomic policy dilemma
    (Week 1)
  • do I stabilize unemployment/output (at the
    expense of more inflation)?
  • or do I stabilize inflation? (at the expense of
    more unemployment/less output)
  • The choice depends essentially on CBs

  • a) If CB cares a lot about employment (i.e.
    attach a relatively high weight to employment
    stabilization), the resulting inflation bias will
    be higher
  • b) If CB cares a lot about inflation (i.e. attach
    a relatively hight weigh to inflation
    stabilization) then inflation will be stabilized
    at the expense of more unemployment.
  • ..dont you think it should be countries

  • a) Inflation is bad. Dont forget that. Supply
    shocks are indeed very hard to deal with, but
    there is a way to do that without worsening
    inflation facilitate market adjustment (wage
    moderation, costs reductions, technology
  • b) If you dont believe a). Remember the three
    prices of money..if we harmonize two of them
    (interest rate, exchange rate) well have to deal
    with the third one as well (inflation rate).
  • And if we have to do that, we should harmonize
    the ultimate determinants of inflation bias..
  • Different central bankspreferences.

  • They are not as evident as they looked at first
    sight, arent they?
  • Asymmetric shocks (at the heart of OCA theory)
    are not likely.
  • Countries are indeed different in some aspects
    (labour market, financial market) that can play a
    role in increasing divergence after a shock. But
  • a) Are we saying that countries must be
    equal in all respects to be able to form a
    monetary union?
  • b) Further integration step will (have to)
    harmonize those differences

  • Countries are not really free to choose their
    most preferred combination of inflation-unemployme
    nt trade off, because in the long-run there is
    simply no trade off
  • And in the short-run?
  • If macroeconomic policies are used to push ouput
    above potential then loosing them (by joining a
    monetary union) is a good thing.
  • If macroeconomic policies are used to offset
    asymmetric supply shock then if we want to
    create a single currency we also have to
    harmonize inflation, and thus we have to
    harmonize CBs preferences on inflation (and
    remember that inflation is bad). But what are
    asymmetric supply shocks?!?!?!

  • If macroeconomic policies are used to offset
    asymmetric demand shock
  • Go back to point 1) how likely they are
  • All right, all right..theoretically, this is
    indeed a true cost of a monetary union.
  • But what about the benefits?

The benefits of a single currency
  • Macroeconomic costs.
  • Microeconomic benefits.
  • a) elimination of transaction costs
  • b) elimination of exchange rate risk
  • c) international currency

a1)Direct benefits from elimination of
transaction costs
  • It is the most visible (although less
    quantifiable) gain from a monetary union.
  • We might try to quantify the benefits in terms of
    commissions, and so on.
  • But we know the most important issue
    here..without the single currency, all the
    previous integration steps would have been
    meaningless (supermarket with different
  • Which leads us to.

a2)Indirect benefits from elimination of
transaction costs
  • Price transparency
  • Goods and services prices are easily comparable
    across the Union.
  • This effect is greater the more competition we
    have in the single market (link with Andrea
    Mantovanis course).

b) No exchange rate risk
  • Uncertainty about the future value of exchange
    rate (under a flexible regime) can have severe
    consequences on
  • a) trade
  • b) investment (real and financial)
  • c) growth
  • d) consumption (through imports)
  • So why dont you adopt a fixed exchange rate
  • The required macroeconomic harmonization (the
    three prices of currency) is impossible under
    free movement of capital (second floor of the
    European integration).

c) international currency
  • Creating a new currency which is likely to be
    adopted outside the area has two types of
  • a) Balance-sheet of CB increases (and decreases
    passivity on balance of payment capital account)
  • b) financial market expands (week 10)

Costs vs Benefits (read ch.4)
  • No doubt the greater cost of forming a monetary
    union is the lost of national macroeconomic
    stabilization policies after asymmetric demand
  • This remark can surely be mitigated by the deeper
    analysis we carried out on aggregate demand
    management. But it still remains.
  • Benefits are also noteworthy all the advantages
    from having a common market cannot be fully
    exploited without a single currency.
  • And dont forget the foundations of the building.

  • What we know
  • a) What is EU integration
  • b) What is macroeconomic policy and how it works
  • c) Costs (lost of most national macro tools) and
    benefits (micro benefits and full integration) of
    a monetary union
  • What well talk about next week
  • Since EMU means having a single central bankhow
    does ECB work?
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