International finance The optimum currency area theory

International finance Lecture outline  The Mundell, McKinnon and Kenen models  The „new” OCA theory  The comparative approach  The endogeneity of OCA

International finance The Mundell model  Assumptions  two countries  full employment  BP in equilibrium  short term price and wage rigidity

International finance The Mundell model  Demand shock analysis  Two cases:  different currencies in two countries  currency union

International finance The Mundell model  Demand increases for country A products  Demand decreases for country B products  Inflationary pressures in country A, unemployment growth in country B  If countries use separate currencies  ER adjustments

International finance The Mundell model  In case of a currency union:  Expansionary monetary policy in country B causes inflationary pressures in country A  Worsening of terms of trade in country A versus country B  The need to adjust demand shocks by other means than ER- labour force mobility

International finance The Mundell model Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000

International finance The Mundell model Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000

International finance Modifying assumptions  Modifying the assumption of price and wage rigidity  new adjustment instruments  Labour market flexibility

International finance Adjustment through prices and wages changes Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000

International finance Conlusions from the Mundell model  If two economies characterized by price and wage rigidity want to introduce a currency union they should ensure labour force mobility

International finance The McKinnon model  The comparison of the utility of two instruments reinstating the external equilibrium depending on the openness of the economy :  Flexible ER  Internal monetary and fiscal policy  The openness of the economy – the ratio of tradable and nontradable products in the production and consumption structure

International finance The McKinnon model  Assumptions:  Two economies - different openness  No factor mobility

International finance The McKinnon model  An open economy  Flexible ER as a mean of maintaining the external equilibrium  Growing demand for tradables  current account deficit

International finance The McKinnon model  Devaluation  price increase of the imported goods vs. nontradables  supply growth of tradables and demand growth for nontradables  BP equilibrium reinstated but  the tradables price increase is permanent

International finance The McKinnon model  External equilibrium reinstatement by contractionary fiscal policy  Influence on employment???  The effect of BP improvement outperforms the effect of employment reduction depending on the grade of openness

International finance The McKinnon model  A less open economy  Demand grows for tradables  current account deficit  Devaluation  price increase of the imported goods vs. nontradables  supply growth of tradables and demand growth for nontradables  BP equilibrium reinstated

International finance The McKinnon model  Contractionary fiscal policy  the influence mostly on the nontradables sector  High share of nontradables  unemployment increase

International finance The McKinnon model Source: Own elaboration based on: K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006

International finance Conclusions from the McKinnon model  The higher the grade of openness of economy the lower is the efficiency of a flexible ER as an adjustment tool and the higher is its negative influence on price stability

International finance The Kenen model  Assumptions:  Two economies with different production structure diversification  Factor mobility  Demand shocks analysis

International finance The Kenen model  Demand shock  internal equilibrium exacerbated  The effect on external balance depends on the grade of diversification  Higher diversification  shocks concern only a part of the production/exports

International finance Conclusions from the Kenen model  Countries can create a currency union provided a diversified export structure is ensured  An economy with higher production diversification does not have to use the ER as adjustment tool as often as a less diversified economy

International finance The optimalisation criteria deriving from the „old” theory  factor mobility  labour market flexibility  the openness of the economy  production diversification

International finance The drawbacks of the „old” theory  Rigid prices assumption  Demand side approach  The only cost of monetary integration is the loss of ER as adjustment instrument  Consideration of the cost of monetary integration, the advantages are neglected

International finance „The „new” OCA theory  Keynesian assumptions rejected  Ingram (1969)- integration of financial markets  Haberler (1970) and Fleming (1971)- inflation rates similarity  Corden (1972) and Giersch (1973)- inflation preferences similarity

International finance Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,

International finance Opracowanie własne na podstawie P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,

International finance The Barro-Gordon model  Monetary policy credibility analysis after establishing a monetary union  Rational inflation expectations  U-Un=α(Лe-Л)

International finance The Barro-Gordon model  Different preferences concerning the restrictiveness of the monetary policy  In one of the countries the CB is not credible  the inflation target is not fulfilled  Rational expectations  price increase  Currency union  there is only one common inflation level set by a supranational CB

International finance The Barro-Gordon model Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,

International finance Coclusions from the Barro- Gordon model  The establishment of a currency union may influence positively the credibility of the monetary policy of a country, which previously led an inefficient monetary policy  The condition: the supranational CB conducts a monetary policy designed as the policy of the country with the lowest inflation

International finance The advantages of creating a monetary union  Creating a monetary union  monetary credibility increase and the decrease of risk premium+ ER risk elimination  A single decrease of the risk premium contributes to production growth  Learning effects, effects of scale and additional capital accumulation  potential increase of productivity in the long term

International finance The advantages of creating a monetary union Source: Own elaboration based on: de Grauwe, op. cit

International finance The comparative OCA approach  Assessing the gains and losses related to monetary unification  The Keynesian and monetarist approach  The extent of gains and losses depends on the assessment of the ER efficiency as adjustment tool

International finance The comparative OCA approach Source: Own elaboration based on: de Grauwe, op.cit.

International finance The comparative OCA approach  Krugman’s approach vs. European Commission’s approach  The symmetry of shocks as optimalisation criterion  The influence of trade integration on the symmetry of shocks

International finance The endogeneity of OCA  The influence of trade integration on the assymetry of shocks  Countries which do not fulfill the OCA criteria ex ante may fulfill them ex psot  Empirical evidence Bayoumi and Eichengreen (1996), Frankel and Rose (1996)

International finance The endogeneity of OCA  One can not assess the fulfilment of the OCA criteria on the base of historical data  Endogenous processes within currency unions  Positive correlation between trade intensity and business cycle correlation

International finance Source: Own elaboration based on: F. Mongelli, „New“ views on the optimum currency area theory: what is EMU telling us?, ECB Working Paper no. 138, ECB, Frankfurt am Main 2002, The endogeneity of OCA

International finance Summing up  Some of the OCA criteria:  Factor mobility  Labour market flexibility  The openness of the economy  Production diversification  Symmetry of shocks  Financial integration  Similarity of inflation levels

International finance Summing up  „The old” and „the new” OCA theory  The assesmesnt of the ER efficiency as an economic policy tool  The comparative approach- Krugman vs. EC  The endogeneity of OCA

International finance References  A. Alesina, R. Barro, Currency unions, Quarterly journal of Economics, 2002  T. Bayoumi, The formal model of optimum currency areas, IMF Staff Papers, vol. 41, 1994,  T. Bayoumi, B. Eichengreen, Ever closer to heaven? An optimum currency area index for European countries, European Economic Review no.41, 1997  J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000  J. Frankel, A. Rose, The endogeneity of the optimum currency area criteria, NBER Working Paper, Cambridge 1996

International finance References  P. De Grauwe, Economics of monetary union, Oxford University Press,  P. Kenen, The theory of optimum currency areas: an eclectic view w: Monetary problems of the international economy, The University of Chicago Press, Chicago & London 1969  R. McKinnon, Optimum currency areas, The American Economic Review vol. 53, 1963  R. Mundell, A theory of optimum currency areas, The American Economic Review vol. 51, 1961  K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006