Monetary Integration By: Jia Ling Royce Yu Econ-515 Spring 2005

Monetary Integration What is MI ? What is MI ? the transition from multiple currencies to one currency.the transition from multiple currencies to one currency. coordination of monetary policies of multi-currencies for monetary stability.coordination of monetary policies of multi-currencies for monetary stability. Why nations need MI? Why nations need MI? to avoid vulnerability and instability of multiple currencies.to avoid vulnerability and instability of multiple currencies.

How to Do MI Surrender’s approach Surrender’s approach dolarization (market).dolarization (market). Government mandate Government mandate unification(shock therapy).unification(shock therapy). Partner’s approach Partner’s approach agreements(institutional approach).agreements(institutional approach).

Theory about MI(1) Fixed exchange rate system Fixed exchange rate system gold standard, US dollar system.gold standard, US dollar system. Flexible exchange rate system Flexible exchange rate system pegged, band, crawling.pegged, band, crawling. Floating rate Floating rate market driven.market driven.

Theory about MI(2) Optimum Currency Areas Optimum Currency Areas rooted in Keynesian tradition.rooted in Keynesian tradition. assumptions: price level and wage level of an economy are rigid.assumptions: price level and wage level of an economy are rigid. besides flexible rate: alternative? How effective compared with flexible rate?besides flexible rate: alternative? How effective compared with flexible rate? three criterions to exam:three criterions to exam: the degree of factor mobility. the degree of factor mobility. the degree of openness. the degree of openness. the degree of coordination of fiscal policies. the degree of coordination of fiscal policies.

Theory about MI (3) OCA: In areas where exist symmetric incidence of shocks and real wage rate flexibility as well as mobility of labor, an optimum currency area can be formed so as to gain better efficiency of transaction and welfare benefit than an exchange rate flexibility can offer (Mundell, 1961).

Theory about MI (4) The father of the Theory of OCAs: The father of the Theory of OCAs: Professor Robert Mundell.Professor Robert Mundell Nobel Laureate.1999 Nobel Laureate. He initiated it in 1961.He initiated it in 1961.

Theory about MI (5) Self_Validating OCA (two equilibria identified) Self_Validating OCA (two equilibria identified) in the first equilibrium local pricing; foreign price determined by the Law of One Price. Optimal policy rules then target the domestic output gap and floating exchange rates support the flex-price allocation.in the first equilibrium local pricing; foreign price determined by the Law of One Price. Optimal policy rules then target the domestic output gap and floating exchange rates support the flex-price allocation. in the second equilibrium local pricing; a monetary union is the optimal policy choice for all countries.in the second equilibrium local pricing; a monetary union is the optimal policy choice for all countries. Benefit:Although business cycles more synchronized with a common currency, flexible exchange rates are superior in terms of welfare. Benefit:Although business cycles more synchronized with a common currency, flexible exchange rates are superior in terms of welfare.

Past efforts of MI from US dollar system to MI from US dollar system to MI An exercise of political economy.An exercise of political economy. Three alternative ways:Three alternative ways: market approach (Panama). market approach (Panama). institutional approach (EU). institutional approach (EU). a shock therapy (Germany, ). a shock therapy (Germany, ).

Present issues Policies tied to low-inflation target (2.8%). Policies tied to low-inflation target (2.8%). Policies constrained by the pursuit of a balanced-budget. Policies constrained by the pursuit of a balanced-budget. Cost of time consuming coordinations and complex procedures. Cost of time consuming coordinations and complex procedures. Uneven political and economic commitment: balancing for growth and gain. Uneven political and economic commitment: balancing for growth and gain.

Future Issues Expansion Expansion drive neighboring countries to feel pressured to join in.drive neighboring countries to feel pressured to join in. to counteract divergences: labor mobility.to counteract divergences: labor mobility. Deeper integration: financial market and political coordination. Deeper integration: financial market and political coordination. The journey has just started. The journey has just started.

Pros Lowers transaction costs Lowers transaction costs Reduce uncertainties Reduce uncertainties Ends currency instability in the participating countries Ends currency instability in the participating countries Lowers interest rates Lowers interest rates

Cons Loss of some macro policy independence. Loss of some macro policy independence. Loss of some national sovereignty Loss of some national sovereignty Introduction cost Introduction cost Loss of some seigniorage Loss of some seigniorage

Requirements Based on Maastricht Treaty in Dec.1991 Inflation L.T. interest rate Devalua- tion Budget deficit Debt <1.5% higher <2% higher Not present in the previous years <3% of its GDP <60% of its GDP