Optimum Currency Areas (Hard pegs vs. Floating) Tomáš Holub International Macroeconomics FSV UK, 19 April 2016

Bipolar View (i) Source: IMF; Fischer (2001) Note: A methodological change increased the number of soft pegs between 2001 and 2008 (reclassification of CFA Franc Zone, 14 countries) ?

Bipolar View (ii) Some renaissance of conventional pegs since the mid- 2000s, but here we are interested in the polar choices. ?

1999 Belgium Germany Ireland Spain France Italy Luxembourg Netherlands Austria Portugal Finland 2001 Greece 2007 Slovenia 2008 Cyprus Malta 2009 Slovakia 2011 Estonia Euro Adoption Debate ? 2015 Lithuania 2014 Latvia

OCA theory - textbook approach  cost and benefits of monetary integration  alternative adjustment mechanisms Inflation, monetary policy credibility and OCA  extension of the Obstfeld model  hard pegs in emerging market economies  real exchange rate appreciation and euro adoption Endogenous nature of OCA criteria  synchronisation vs. specialisation hypothesis (Krugman) OUTLINE

Optimum Currency Areas Cost-benefit analysis; Benefits: reduction of transaction costs, elimination of ER volatility, support for mutual trade. Costs: loss of own MP + ER changes as adjustment tools (↓ with symmetry of shocks); Wage/price flexibility, factor mobility, and counter-cyclical FP can partly substitute MP. Join union if  *.

MP credibility and OCA Some current EA members adopted the euro partly to import price stability from Germany; This factor was relevant also for some of the new EU member states; This additional benefit can by nicely analysed within the dynamic inconsistency model / Obstfeld model.

Dynamic Inconsistency Model Phillips Curve Loss Function Output Target Reaction Function

Obstfeld Model Revisited If ER fixed: If ER floated

Hard Peg vs. Floating If ER remains always fixed (hard peg,  E =  =0 ): If ER floats (  E =k/  ): Rational decision for hard peg:

Extended Model Rational decision for hard peg: If ER remains always fixed (hard peg;  E =0):

Graphical Illustration Hard peg if  *. Hard peg better if  high and MP credibility low.

OCA + Import of Credibility Lack of domestic policy MP credibility and competence increases benefits of entry; Similarly with excess ER volatility (shock absorber vs. shock generator); Argument for dollarisation or euroisation in some EMEs. Join union if  **.

On the other hand, in catching-up economies that have already achieved price stability (like CZ), inflation may actually increase after the euro adoption; Real appreciation trend: it can go through (i) an inflation differential; (ii) nominal ER appreciation; (iii) a combination of these. The monetary policy and exchange rate regime decides which channel is more important; After the euro adoption, only the inflation channel remains open. Real Appreciation Trend and the Euro Adoption

Exchange Rate or Inflation Channel? CZ HU PLSK Nominal exchange rate channel starts to dominate with a floating exchange rate once disinflation is achieved; HU: inflation channel clearly dominant. Source: Komárek, Král, Koprnická

Exchange Rate or Inflation Channel? EE LT LVSI Inflation channel dominant under fixed exchange rate regime (if fixed against EUR – see LT a LV). Source: Komárek, Král, Koprnická

Extended Model (ii) Rational decision for hard peg: If ER remains always fixed (hard peg;  E =c ):

Endogeneity of OCA Criteria Entry into a monetary union can itself increase the degree of integration beyond the break-even point; Frankel and Rose (1998): Being in a monetary union increases mutual trade considerably (estimated elasticity in fact disputed as implausibly high; see e.g. Havránek, 2009); Hochreiter and Winckler (1995): Fiscal policy, wage flexibility etc. may adjust to create OCA ex post (Austria as a case study; but: it did not work e.g. in Greece!); vs. Krugman (1993): “Specialisation hypotheses” (more trade leads to less symmetry - exploiting comparative advantages); In the end: degree of integration and its break-even point very uncertain; integration a political decision.

OCA theory – benefits of monetary integration should outweigh the costs in or to adopt a hard peg; Benefits: reduced ER volatility, lower transaction costs, import of low inflation (only for some countries); Costs: giving-up own MP and ER as adjustment tools; Cost fall down with the degree of economic integration; Endogeneity of OCA criteria – so far does not seem to be working. SUMMARY