Monetary integration José Villaverde Castro Universidad de Cantabria This slides are based on the book “Economics of Monetary Union”, by P. De Grauwe. OUP.

Outline of the presentation Degrees of economic integration Concept of a monetary union The costs of a monetary union The benefits of a monetary union Costs and benefits compared

Degrees of economic integration No visible trade restrictions Common external trade restrictions No invisible trade restrictions Free mobility of factors and assets Common currency Common economic policy Free trade area X Custom union Internal commodity market Common market Monetary union Economic union

Concept of a monetary union Common currency Common central bank

The costs of a common currency Costs arise because, when joining a monetary union, a country looses policy instrument: monetary policy (e.g. exchange rate, interest rate) This is costly when asymmetric shocks occur Sources of asymmetry: Shifts in demand Different preferences between inflation and unemployment

Shifts in demand (Mundell) Assume two countries, France and Germany Asymmetric shock in demand Need to distinguish between permanent and temporary shock Decline in aggregate demand in France Increase in aggregate demand in Germany We will analyze this shock in two regimes Monetary union Monetary independence

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

First regime: monetary union How can France and Germany deal with this shock if they form a monetary union? Thus France cannot stimulate demand using monetary policy; nor can Germany restrict aggregate demand using monetary policy Do there exist alternative adjustment mechanisms in monetary union? Wage flexibility Labour mobility

The automatic adjustment process (Wage flexibility) France Germany PF PG YF YG

Second regime: Monetary independence France Germany PF PG SG SF DG DF YG YF

Conclusion Thus, when asymmetric shocks occur And when there are a lot of rigidities Monetary union may be more costly than monetary independence What about fiscal policies? (income transfers between countries or between generations)

Fiscal policy Automatic stabilisers: Centralised budget or decentralised budget Centralised budget allows for automatic transfers between countries of the monetary union Decentralised: flexible national budgets France allows deficit to accumulate; Germany allows surplus This imples automatic transfers between generations within the same countries Create problems of debt accumulation and sustainability

Other sources of asymmetries: Different preferences about inflation and unemployment  

Germany C B e Italy A C’

Other sources of asymmetry (In the response to shocks) Different labour market institutions (supply shocks): Centralized versus non-centralized wage bargaining. Different financial systems Different growth rates Different fiscal systems: Goverment budget constraint: (G-T-rB= dB/dt + dM/dt)

Symetric shocks in a monetary union France Germany PF PG YF YG

The benefits of a common currency The costs of EMU have mostly to do with macroeconomic management The benefits are mostly microeconomic in nature: they arise from efficiency gains

Sources of benefits Less transactions costs: Direct and Indirect effects (Price transparency) Less uncertainty: No exchange rate risk Benefits of an international currency Does monetary union lead to more economic growth?

Less transactions costs Elimination of foreign exchange markets within union eliminates cost of exchanging one currency into another Cost reductions amount to 0.25 to 0.5% of GDP (according to European Commission)

Price transparency One common unit of account facilitates price comparisons: Consumers “shop around” more. Competition increases. Prices decline and consumers gain.

Less exchange risk Euro eliminates exchange risk. Less uncertainty. Increase welfare Does the decline in exchange risk increase welfare?

Monetary Union and economic growth Neo-classical growth model y r f(k) A r k

Potential growth effects of monetary union MU eliminates exchange risk and may reduce systemic risk. If so, real interest rate declines rr-line becomes flatter (r’r’) Economy moves from A to B Per capita income increases because of capital accumulation Economic growth increases during transition from A to B y r r’ B f(k) A r’ r k

Endogenous growth and monetary union Capital accumulation can lead to dynamic effects leading to technological innovations. Production function f(k) then shifts outwards raising economic growth y C f’(k) B f(k) A k

Benefits of an international currency International use of the dollar creates seigniorage gains for the US Similarly, if euro becomes an international currency, seigniorage gains will follow for Euroland These gains, however, remain relatively small: in the case of the US: less than 0.5% of GDP per year

Benefits of monetary union and openness Benefits of monetary union are likely to be larger for relatively open economies In absence of monetary union, transactions costs and exchange risk are larger for firms in very open economies Monetary union will be more beneficial for firms in very open economies Upward sloping benefit line Benefits (% of GDP) Trade (% of GDP)

The cost of a monetary union and the openness of a country 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, and are more resilient Cost (% of GDP) Trade (% of GDP

Costs and benefits of a monetary union Costs and Benefits (% GDP) Costs Trade (% GDP)

Two views about costs and benefits of MU (a) The monetarist view (b) The Keynesian view Benefits Benefits Costs and benefits Costs and benefits Costs Costs T* T* Trade (% GDP) Trade (%GDP)

Two views about costs of MU The 'monetarist‘ view : Monetary policies are ineffective as instruments to correct for different developments between countries. The cost curve is close to the origin. Thus, many countries in the world would gain by relinquishing their national currencies, and by joining a monetary union.

The 'Keynesian' view : the world is full of rigidities Monetary policy (including exchange rate policy) is a powerful instrument in eliminating disequilibria the cost curve is far away from the origin relatively few countries should find it in their interest to join a monetary union

Costs and benefits with decreasing rigidities With decline in wage and price rigidities and an increase in labour mobility: Cost curve shifts downwards Monetary union becomes more attractive Benefits Costs and benefits Costs T* T** Trade (% GDP)