Chapter 2: The Theory of Optimum Currency Areas: A Critique De Grauwe: Economics of Monetary Union

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 view symmetry Trade integration

Figure 2.2: Pessimistic view symmetry 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. 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

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

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

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

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

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

How effective are national monetary policies?

Two disturbances are analyzed 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 2.7: 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 S’F(W2) SF(W1) F’ F D’F DF YF

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 P P Y Y

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

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

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

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

Figure 2.7: Monetary Union in a world of vertical Phillips Curves Germany Italy

An aside: Productivity and inflation in monetary union The Balassa-Samuelson effect Inflation differentials in monetary union can be significant Average yearly inflation in Eurozone countries, 1999-2005 (%)

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

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

National monetary policies, 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 model Figure 2.9: The Phillips curve and natural unemployment . p 2 1 e = N U 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

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

Figure 2.13: The preferences of the authorities ‘Hard-nosed’ government ‘Wet’ government I3 I2 I3 I1 I2 I1 ‘Hard-nosed’ government attaches a lot of weight to fighting inflation U ‘Wet’ government attaches a lot of weight to fighting unemployment U

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

Figure 2.15: Equilibrium with ‘hard-nosed’ and ‘wet’ governments ‘Hard-nosed’ government ‘Wet’ government E E B B A A UN U UN U ‘Hard-nosed’ government achieves lower inflation equilibrium than ‘wet’ government without imposing more unemployment in the long run

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 UN U’N U

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.

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)

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

Optimal stabilisation and monetary union Figure 2.18: Optimal stabilization in country with high preference for unemployment stability A B C B’ U UU UN U1 U2 π1 UL 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

Figure 2.19: Optimal stabilization in country with low preference for unemployment stability 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 Figure 2.20: Effectiveness of currency depreciation as a function of openness Very open country PO PC Relatively closed country SO SC DO DC YC YO

Figure 2.21: The cost of a monetary union and the openness of a country (% 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