chapter 2 06-07
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Chapter 2
The Theory of Optimum Currency Areas: A Critique
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?
How relevant are the differences between countries?
Should we worry?Let’s analyze these differences
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
Figure 2.1 Optimistic viewdivergence
Trade integration
Figure 2.2 Pessimistic viewdivergence
Trade integration
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
2. Asymmetric shocks and the nation-state
Existence of nation-states is a source of asymmetric shocks Taxation and spending remains in
realm of national soveignty Social policies are national Wage policies
This creates a need for further political integration in a monetary union
Additional explanations: Beggar-Thy-Neighbour in the Eurozone
Nominal wage increases (in %)
0
1
2
3
4
5
6
7
2000 2001 2002 2003 2004 2005 2006
perc
ent i
ncre
ase
Germany
Eurozone
US
UK
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
Dramatic effect on competitive positions within the Eurozone
Real effective exchange rates (ULC) within Eurozone
80
85
90
95
100
105
110
115
120
1998 1999 2000 2001 2002 2003 2004 2005
ULC
BLEUDenmarkGermanyGreeceSpainFranceIrelandItalyNetherlAustriaPortugalFinland
Index is based on ULC (takes into account productivity differentials)
Germany improves its competitive position
At the expense of many other Eurozone countries
3. 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
4. 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
Is national monetary policy effective?
Nominal and real depreciations of currencies 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
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
Figure 2.5 Prices and cost effects of a national monetary policy
PF
YF
DF
D’F
SF(W1)
S’F(W2)
F
F’
After monetary expansion real wage declinesWorkers will want to be compensated by higher nominal wageSupply shifts upwards thereby reducing output effect of monetary expansionEffectiveness of monetaey policy is reducedIt does not make a difference whether country is in MU
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
Adjustment through deflation
Adjustment through monetary expansion
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.
PF PG
YF YG
France Germany
Figure 1.1 Aggregate demand and supply in France and Germany
DFDG
SFSG
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.
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.
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.
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.
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.
An aside: Productivity and inflation in monetary union
The Balassa-Samuelson effect Inflation differentials in monetary union can be
significantAverage yearly inflation in Eurozone countries, 1999-2003 (%)
0,0
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
D A F B FIN Euro LUX I NL E EL P IRL
Infla
tion
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
FFF wpcp...
)1(
III wpcp...
)1(
IF pp..
))(1(....IFIF wwpccp
))(1(....IFIF qqpccp
should wage bargaining be centralized in monetary union?
IFIF qqww
•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
How credible are national monetary policies?
Devaluation, time consistency, and credibility
Credibility affects the effectiveness of policies
We use Barro-Gordon model We first develop closed-economy
version Then we develop two-country
version
Barro-Gordon modelFigure 2.9 The Phillips curve and natural unemployment .p
2.p
1.p
.2
.ppe
.1
.ppe
NU U
0.
ep
•There is a short-term tradeoff 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
.. epp
U
I3
I2
I1
Figure 2.10 The preferences of the authorities
p•Indifference curves are concave
•Slope expresses relative importance attached to fighting inflation versus fighting unemployment
p
U
I3
I2
I1
Figure 2.11 The preferences of the authorities
U
‘Hard-nosed’ government ‘Wet’ government
I1
I2
I3
p
•‘Hard-nosed’ government attaches a lot of weight to fighting inflation
•‘Wet’ government attaches a lot of weight to fighting unemployment
Figure 2.12 The equilibrium inflation rate
p
U
1p
UN
1ppe
0ep
B
C
E
A
•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 id the rational expectations time consistent equilibrium
p
U
Figure 2.13 Equilibrium with ‘hard-nosed’ and ‘wet’ governments
U
‘Hard-nosed’ government ‘Wet’ government
p
UN UN
AB
E
A
B
E
•‘Hard-nosed’ government achieves lower inflation equilibrium than ‘wet’ government without imposing more unemployment in the long run
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.
GI ppe
UG
How can Italy reach a more attractive (lower) inflation equilibrium?
UI
Germany Italy
Ip
A
E
C
G
FGp
Gp
Fixing the exchange rate of the lira with the mark is not credible, because Italian authorities have an incentive to create surprise inflation (devaluation)
Only by abolishing the Italian central bank and adopting 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
Optimal stabilisation and monetary union
A
B
C
B’
U
UU
UN U1 U2
π1
UL
•Dotted line is optimal stablisation 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
A
B
CB’
U
UU
UN U1 U2
π2
•This country cares less about unemployment•Same shock will lead to stronger increase in unemployment•But less inflation
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.
Cost of monetary union and openness
PO PC
YOYC
DO
SO
DC
SC
Figure 2.16 Effectiveness of devaluation as a function of openness
Very open country Relatively closed country
Figure 2.17 The cost of a monetary union and the openness of a country
Cost(% of GDP)
Trade (% 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 instument of policy that is relatively ineffective
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