Chapter 2: The Theory of Optimum Currency Areas: A Critique

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Chapter 2The Theory of Optimum Currency Areas
A Critique

• De Grauwe
• Economics of Monetary Union

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• 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?

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How relevant are the differences between
countries?

• Should we worry?
• Lets analyze these differences

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1. 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

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Figure 2.1 Optimistic view
symmetry
Trade integration
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Figure 2.2 Pessimistic view
symmetry
Trade integration
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• 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

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2. 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

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3. 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

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4. 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

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Recent 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
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Dramatic 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
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5. 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

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• How effective are national monetary policies?

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• 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

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Permanent 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

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Figure 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
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However

• 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

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Adjustment through deflation
Adjustment through monetary expansion
P
P
Y
Y
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National 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

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Figure 1.1 Aggregate demand and supply in France
and Germany
France
Germany
PF
SG
PG
SF
DG
DF
YG
YF
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• 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.

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• 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

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• 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

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• 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

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• 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

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Currency 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

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Figure 2.7 Monetary Union in a world of vertical
Phillips Curves
Germany
0
Italy
0
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An 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 ()
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Balassa-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

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Should 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

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National monetary policies, time consistency and
credibility
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• Credibility affects the effectiveness of policies
• We use Barro-Gordon model
• We first develop closed-economy version
• Then we develop two-country version

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Barro-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

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Figure 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
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Figure 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

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Figure 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
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Figure 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

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Figure 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
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The 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.

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How 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)
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• 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

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Optimal 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

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Figure 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

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• 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

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Cost 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
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Figure 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