European Economic and Monetary Integration EXAM DATE● Exam: April 2● Time: 5.30 pm –

7.30 pm● Place: to be

announced

Points to Remember for Presentation● Content:

Does the presentation address the necessary points? Are the points clear?● Organization:

Is the presentation well prepared? Is the level of treatment appropriate? (Not too detailed or too general) Is the presentation easy to follow with smooth continuity?

● Delivery: Is the presenter energetic and enthusiastic? Is the presentation well practiced? Presentation should have very little reading from notes Does the speaker have clear, good volume with no

mumbling? Is the presentation on time? (Without need to go over time)

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

words?● 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 presentations?

Different Fiscal Systems and the Seigniorage Problem

● Countries have different fiscal systems

● This leads countries to use different debt and monetary financing of the government budget deficit

● 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 inflation

● Countries will have different optimal inflation rates

● 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 inflation This means they will have to increase taxes

● Leads to a loss of welfare

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 Bank 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

shock Ex: if ECB reduces interest rates to stimulate demand

in France – it increases inflation in Germany 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 shocks)

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:1. The differences between countries may not be all that

important2. The exchange rate mechanism may not be very

effective in correcting for differences between nations

3. 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 unification?

● 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:1. European Commission view2. 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 asymmetric

Paul Krugman’s 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

USA EU

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 Krugman’s 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. ViewAs 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 involved)

Paul Krugman’s 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 because:1. 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 relevant

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

2. Empirical analysis suggests that economic integration will make asymmetric shocks between nations less likely

3. The rise of services: economies of scale do not matter as much for services as for industrial activities

Economic integration does not lead to regional concentration of services in the way it does with industries

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 countries

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 necessary

● 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 There’s 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)

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 support● 1. Paul Krugman’s reason against this view:

Economic growth is rarely like the scenario mentioned above

it usually has to do with the development of new products

there is higher income elasticity on their exports 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 country 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 uncertainty)

● 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 one’s 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 (cont.)

● 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

devaluations● 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 (cont.)

● 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 differences

● 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 period

1. Devaluations to correct for asymmetric shocks (cont.)

● 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 preferences● 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 preferences

● 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 THIS IS NOT TRUE!! 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

CONCLUSION

● The traditional theory of OCA’s 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 pessimistic

● The main reasons:1. 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

CONCLUSION (cont.)

2. Countries that maintain independent monetary and exchange rate policies often find out that exchange rate movements can lead to macroeconomic disturbances instead of macroeconomic stabilization

Exchange rates, contrary to popular belief, cannot be used frequently and costlessly

CONCLUSION (cont.)

● 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 future

CONCLUSION (cont.)

● The risks of high adjustment costs in the face of asymmetric disturbances can be reduced by:

1. Making markets more flexible (so that asymmetric shocks can be adjusted better)

2. 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.)

1. Direct gains from the elimination of transaction costs

● 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 billion/year

● Of course banks will lose revenue they get for exchanging national currencies in a monetary union

Benefits of a Common Currency (cont.)

2. Indirect gains from the elimination of transaction costs

● The scope for price discrimination between national markets will be reduced

● (TABLE HERE)● 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.)

3. Welfare gains from less uncertainty

● The uncertainty about future exchange rate cahnges introduces uncertainty about future firm revenues

● Welfare of firms will increase when common currency is introduced (exception: firms that make money by taking on risk)