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European Economic and Monetary Integration EXAM DATE


European Economic and Monetary Integration EXAM DATE Exam: April 2 Time: 5.30 pm 7.30 pm Place: to be announced ... – PowerPoint PPT presentation

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Title: European Economic and Monetary Integration EXAM DATE

European Economic and Monetary Integration EXAM
  • Exam April 2
  • Time 5.30 pm 7.30 pm
  • Place to be announced

Points to Remember for Presentation
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Points to Remember for Presentation (cont.)
  • Format
  • Are the presentation slides large enough to read
    without too much crowding on one slide?
  • Are the visuals sufficient?
  • Are appropriate graphics used?
  • Any misspellings, poor grammar or misuse of
  • Overall Excellence
  • Out of all of the presentations you have seen
    today, was this presentation among the best, one
    of the good, one of the average or one of the bad

Different Fiscal Systems and the Seigniorage
  • Countries have different fiscal systems
  • This leads countries to use different debt and
    monetary financing of the government budget
  • In a monetary union countries will be constrained
    in the way they finance their budget deficits

Theory of Optimal Public Finance
  • Rational governments will use different sources
    of revenue so that the marginal cost of raising
    revenue through different means is equalized
  • If the marginal cost of raising revenue by
    increasing taxes exceeds the marginal cost of
    raising revenues inflation (seigniorage) it
    will be optimal to reduce taxes and to increase
  • Countries will have different optimal inflation
  • Generally countries with an underdeveloped tax
    system will find it more advantageous to raise
    revenues by inflation (seigniorage)

Different Fiscal Systems and the Seigniorage
Problem Main Point
  • Less Developed Countries that join a monetary
    union with more developed countries that have a
    low rate of inflation will also have to lower
  • This means they will have to increase taxes
  • Leads to a loss of welfare

Seigniorage Revenues (as of GDP) Seigniorage Revenues (as of GDP) Seigniorage Revenues (as of GDP) Seigniorage Revenues (as of GDP)
1976-85 1986-90 1993
Germany 0,2 0,6 0,5
Greece 3,4 1,5 0,7
Italy 2,6 0,7 0,5
Portugal 3,4 1,9 0,6
Spain 2,9 0,8 0,6
What About Symmetric Shocks?
Can France and Germany deal with this negative
shock in a monetary union?
Symmetric Shocks
  • France and Germany can deal with a negative shock
    in a monetary union because monetary policy is
    centralized in the hands of the European Central
  • One interest rate for both countries due to ECB
  • If ECB lowers the interest rate it stimulates
    aggregate demand
  • ECB would be paralyzed in case of an asymmetric
  • Ex if ECB reduces interest rates to stimulate
    demand in France it increases inflation in
  • If ECB increases interest rates to deal with
    German inflation it reduces demand in France

If France and Germany are NOT in a monetary union
  • Is devaluation an attractive policy option for
    one of the countries facing a symmetric shock?
  • NO!!
  • Ex France devalues aggregate demand stimuated
    at the expense of Germany
  • This shifts the German aggregate demand curve
    further to the left
  • French export their problem to Germany
  • Then Germany would react with tis own devaluation
    danger of a spiral of devaluations
  • The two countries would have to coordinate their
    actions difficult for 2 independent states
  • There is an advantage of a monetary union when
    faced with symmetric shocks (but not asymmetric

Critique of Optimum Currency Areas
  • So far we have looked at why countries may find
    it costly to join a monetary union
  • This analysis is known as The Theory of Optimum
    Currency Areas (OCA)
  • Criticism of OCA
  • The differences between countries may not be all
    that important
  • The exchange rate mechanism may not be very
    effective in correcting for differences between
  • The exchange rate may do more harm than good in
    the hands of politicians

I. 1. The differences between countries
  • There is no doubt that there are differences
    among countries
  • Question Are these differences important enough
    to represent a stumbling block for monetary
  • Classical Mundell analysis
  • Demand shift from one country to another
  • Is this likely to occur frequently between the
    European countries that form a monetary union?
  • Two views exist
  • European Commission view
  • Paul Krugman view

E.C. View
  • Diferential shocks in demand will occur less in a
    monetary union
  • Reason Trade between the industiral European
    nations is largely intra-industry trade based on
    economies of scale and imperfect competition
  • Countries buy and sell to each other in the same
    category of products (ex. France sells cars to
    and buys cars from Germany)

E.C. View (cont.)
  • This structure of trade leads to most demand
    shocks having similar effects in both countries
  • Ex fewer demand for cars means fewer French and
    German cars get sold demand is affected
    similarly in both countries
  • Removal of barriers in a single market will
    reinforce these tendencies
  • Demand shocks will become symmetric as opposed to

Paul Krugmans View
  • Trade integration leads to regional concentration
    of industrial activities
  • This leads to localization of industries
  • Concentration of production to profit from
    economies of scale
  • Trade integration leads to more concentration of
    regional activities

Regional Distribution of Auto Production, 1991 Regional Distribution of Auto Production, 1991 Regional Distribution of Auto Production, 1991 Regional Distribution of Auto Production, 1991
Midwest 66,3 Germany 38,5
South 25,4 France 31,1
West 5,1 Italy 17,6
North-East 3,32 UK 12,9
Paul Krugmans View (cont.)
  • When the EU becomes more integrated, it may
    become like the USA
  • This suggests that sector-specific shocks may
    become country-specific shocks
  • Countries faced with these shocks may then prefer
    to use the exchange rate as an economic policy to
    correct for disturbances

EC View and Krugman View Compared
Divergence Degree of divergent movments of
output and employment between groups of countries
(regions) which are candidates for a monetary
union Trade Integration Degree of trade
integration between these countries
E. C. View
As the degree of economic integration between
countries increases, asymmetric shocks will occur
less frequently (so that income and employment
will tend to diverge less between the countries
Paul Krugmans View
When economic integration increases the countries
involved become more specialized so that they
will be subjected to more rather than fewer
asymmetric shocks
EC vs. Krugman View
  • There is a presumption in favor of the EC view
  • Even though economic integration can lead to
    concentration and its effects cannot be disputed
    however, as market integration between
    countries proceed national borders become less
    and less important
  • Most likely clusters of economic activity will
    encompass borders
  • Ex auto manufacturing in the region encompassing
    South Germany and North Italy in this case
    shocks in the auto industry will affect more than
    one country
  • The argument is not that concentration will not
    happen but that national borders will become less
  • Regions may as a result experience asymmetric
    shocks regions may overlap existing borders
  • Economic forces of integration are likely to
    decapacitate the exchange rate between national
    currencies as a force to deal with these shocks

EC vs. Krugman View
  • Empirical analysis suggests that economic
    integration will make asymmetric shocks between
    nations less likely
  • The rise of services economies of scale do not
    matter as much for services as for industrial
  • Economic integration does not lead to regional
    concentration of services in the way it does with
  • There is no regional integraiton in services and
    this sector counts for 70 or more of GDP in many
    EU countries

2. Effectiveness of the Exchange Rate Mechanism
  • Not all asymmetric shocks will dissapear
  • This is because nation-states still remain the
    main instruments of economic policies
  • In the European Economic and Monetary Union
    monetary policies are centralized (due to the
    ECB) and therefore cease to be a source of
    asymmetric shocks
  • Member countries however still ahve sovereignty
    in other economic areas
  • Budgetary Field
  • National Economic Institutions

Budgetary Field
  • Most spending and taxing powers still vested in
    the hands of national authorities
  • By changing taxes and spending a nation can
    create asymmetric shocks
  • These shocks will be contained within the borders
    of that nation-state
  • Ex. When a country raises taxes o wage income it
    only affects labor, spending and wage levels in
    that particular country
  • These may lead to asymmetric shocks with other

National Economic Institutions
  • Ex Wage bargaining systems
  • Ex Legal Systems
  • Ex Financial Systems

  • Although economic integration is likely to weaken
    the occurrence of asymmetric shocks the existence
    of nation-states with their own peculiarities
    will be a continued source of asymmetric
    disturbances in a monetary union
  • This has led some economists to argue that in
    order for a monetary union to function
    satisfactorily more political unification is
  • Monetary union should also put pressure on
    further political integration within member states

3. Institutional Differences in Labor Markets
  • Will monetary integration change the behavior of
    labor unions? (so that differences may dissapear)
  • National governments can still create employment
    in the government sector but now finance it by
    issuing debt
  • Thus the effects of labor unions should not be
    completely disregarded
  • Institutional differences in the national labor
    markets will continue to exist leading possibly
    to divergent wage and employment tendencies and
    severe adjustment problems when the exchange rate
    instrument is not available

4. Different Legal and Financial Systems
  • Financial markets work differently across the EU
  • Theres a risk that some monetary shocks will be
    transmitted differently
  • Ex. Investors in high inflation coutnries like
    Italy do not tend to buy long term bonds in
    fact the long term bond market hardly exists
    government debt is mostly short-term it is
    exactly the opposite case in a low-inflation
    country like Germany

4. Different Legal and Financial Systems (cont.)
Maturity distribution of government bonds ( of total) Maturity distribution of government bonds ( of total) Maturity distribution of government bonds ( of total) Maturity distribution of government bonds ( of total)
Short-term (- 1 year) Medium and long term (1 year) Of which long term (5 years)
Italy 49,4 50,6 24,8
Germany 18,5 81,5 -
Netherlands 6,7 93,3 63,0
All this caused asymmetries in the way
EU-governments reacted to the same interest rate
changes in the past Ex. When the interest rate
changed, the Italian government budget was
immediately affected Italian debt has short
maturity, interest rates go up, Italian
government spends more on interest payments,
budget deficit increases These differences due to
inflation will dissapear in a monetary union
4. Different Legal and Financial Systems (cont.)
  • Monetary union by itself will eliminate some of
    the institutional differences that exist between
    national financial systems however deeper
    differences like those that are the result of
    different legal systems will only dissapear by a
    convergence of national legal systems
  • This means further political integration

5. Differences in Growth Rates
  • Fast growing countries fast growing imports
  • Depreciation of currency needed to allow exports
    to grow
  • Monetary union makes this impossible
  • This popular view has very little empirical
  • 1. Paul Krugmans reason against this view
  • Economic growth is rarely like the scenario
    mentioned above
  • it usually has to do with the development of new
  • there is higher income elasticity on their
  • these countries can grow faster without incurring
    trade balance problems
  • No depreciations needed

5. Differences in Growth Rates (cont.)
  • 2. Existence of Capital Flows slow-growing
    countries will invest in the faster-growth
  • Fast-growing country can finance current account
    deficit without devaluing its currency
  • In fact by joining a monetary union, a fast
    growing country may attract more foreign capital
    (since there is also no exchange rate
  • Differences in the growth rates of countries
    cannot really be considered as an obstacle to
    monetary integration

II. Nominal and Real Depreciations of Currency
  • By giving up ones national currency a country
    cannot change its exchange rate any more to
    correct for shocks in demand, costs or prices
  • Question Are these exchange rates effective in
    making such corrections?
  • Do nominal exchange rate changes permanently
    alter the real exchange rate of a country?
  • If the answer is no different countries would
    not have extra costs when joining a monetary union

1. Devaluations to correct for asymmetric shocks
  • In the previous story of France and Germany
    France devalues to cope with the problem

1. Devaluations to correct for asymmetric shocks
  • Nominal exchange rate cahnges have only temporary
    effects on the competitiveness of coutnries.
    Over time the nominal devaluation leads to
    domestic cost and price increases which tend to
    restore the initial competitiveness
  • Nominal devaluations only lead to temporary real
  • Do countries not lose anything by relinquishing
    this instrument?
  • NO!! They do lose something short-term effects
    in the absence of a devaluation

1. Devaluations to correct for asymmetric shocks
  • In the long run the two policies (devaluation and
    expenditure reduction) lead to the same effect on
    output and the trade account
  • In the long run the exchange rate will not solve
    problems that arise from differences between
    countries that originate in the goods markets.
    Manipulating money cannot change the real
  • Their differences are in the short-term effects
  • When a country devalues it avoids severe
    deflationary effects on domestic output during
    transition inflation increases
  • In expenditure-reduction inflation is avoided
    however output decreases during the transition

1. Devaluations to correct for asymmetric shocks
  • Although a devaluation does not have a permanent
    effect on competitiveness and output its dynamics
    will be quite different from the dynamics
    engendered by the alternative policy which will
    necessarily have to be followed if the country
    has relinquished control over its national money
  • This loss of a policy instrument will be a cost
    of the monetary union

2. Devaluations to correct for different policy
  • The model of Italy and Germany and the Phillips
    Curve and the preferences of each one of these
    countries was a concern
  • Both countries would have to accept unpopular
    points in the curve when joining a monetary union

2. Devaluations to correct for different policy
  • This analysis depends on the assumption that the
    Phillips curve is stable which it is not
  • Countries differ in terms of their preferences
    towards inflation and unemployment these
    differences are not a serious obstacle to joining
    a monetary union since countries cannot choose an
    optimal point on the Phillips curve

3. Productivity and inflation in a monetary union
  • Upto now we have assumed that national inflation
    rates will be equalized in a monetary union
  • There are regional differences even though they
    tend to be small they can be significant
  • Ex. When Germany and Ireland are in a monetary
    union competition makes sure that the price
    changes of tradeable goods are equalized
  • But this does not happen in non-tradeable goods
    (like electricity and water) because there is no
    international competition

  • The traditional theory of OCAs tends to be
    rather pessimistic about the possibility for
    countries to join a monetary union at low cost
  • The criticisms we have discussed are much less
  • The main reasons
  • The ability of exchange rate changes to absorb
    asymmetric shocks is weaker than the traditional
    OCA theory has led us to believe
  • Exchange rate changes usually have no permanent
    effects on output and employment

  • Countries that maintain independent monetary and
    exchange rate policies often find out that
    exchange rate movements can lead to macroeconomic
    disturbances instead of macroeconomic
  • Exchange rates, contrary to popular belief,
    cannot be used frequently and costlessly

  • OCA theory though still has relevance because
  • There are differences between countries that have
    political and institutional origins (ex. Labor
    markets, legal systems, governments, ...) which
    will continue to exist
  • These can lead to adjustment problems in the

  • The risks of high adjustment costs in the face of
    asymmetric disturbances can be reduced by
  • Making markets more flexible (so that asymmetric
    shocks can be adjusted better)
  • Speeding up the process of political unification
    (this will reduce the occurance of asymmetric
    disturbances that have a political or
    institutional origin)

Benefits of a Common Currency
  • Costs have to do with macroeconomic management of
    the economy
  • Benefits have to do with the microeconomic aspect
  • Eliminating national currencies for a common
    currency leads to economic efficiency gains
  • Elimination of transaction costs
  • Elimination of exchange rate risk

Benefits of a Common Currency (cont.)
  • Direct gains from the elimination of transaction
  • Eliminating the costs of exchanging one currency
    into another is themost visible gain from a
    monetary union
  • E.C. Estimates these gains between 13-20
  • Of course banks will lose revenue they get for
    exchanging national currencies in a monetary union

Benefits of a Common Currency (cont.)
  • Indirect gains from the elimination of
    transaction costs
  • The scope for price discrimination between
    national markets will be reduced
  • The unification of currency along with the other
    measures in creating a single market will make
    price discrimination more difficult
  • This is a benefit to the European consumer

Benefits of a Common Currency (cont.)
  • Welfare gains from less uncertainty
  • The uncertainty about future exchange rate
    cahnges introduces uncertainty about future firm
  • Welfare of firms will increase when common
    currency is introduced (exception firms that
    make money by taking on risk)