1. International finance 120181-1165 The optimum currency area theory

2. International finance 120181-1165 Lecture outline  The Mundell, McKinnon and Kenen models  The „new” OCA theory  The comparative approach  The endogeneity of OCA

3. International finance 120181-1165 The Mundell model  Assumptions  two countries  full employment  BP in equilibrium  short term price and wage rigidity

4. International finance 120181-1165 The Mundell model  Demand shock analysis  Two cases:  different currencies in two countries  currency union

5. International finance 120181-1165 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

6. International finance 120181-1165 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

7. International finance 120181-1165 The Mundell model Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000

8. International finance 120181-1165 The Mundell model Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000

9. International finance 120181-1165 Modifying assumptions  Modifying the assumption of price and wage rigidity  new adjustment instruments  Labour market flexibility

10. International finance 120181-1165 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

11. International finance 120181-1165 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

12. International finance 120181-1165 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

13. International finance 120181-1165 The McKinnon model  Assumptions:  Two economies - different openness  No factor mobility

14. International finance 120181-1165 The McKinnon model  An open economy  Flexible ER as a mean of maintaining the external equilibrium  Growing demand for tradables  current account deficit

15. International finance 120181-1165 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

16. International finance 120181-1165 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

17. International finance 120181-1165 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

18. International finance 120181-1165 The McKinnon model  Contractionary fiscal policy  the influence mostly on the nontradables sector  High share of nontradables  unemployment increase

19. International finance 120181-1165 The McKinnon model Source: Own elaboration based on: K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006

20. International finance 120181-1165 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

21. International finance 120181-1165 The Kenen model  Assumptions:  Two economies with different production structure diversification  Factor mobility  Demand shocks analysis

22. International finance 120181-1165 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

23. International finance 120181-1165 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

24. International finance 120181-1165 The optimalisation criteria deriving from the „old” theory  factor mobility  labour market flexibility  the openness of the economy  production diversification

25. International finance 120181-1165 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

26. International finance 120181-1165 „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

27. International finance 120181-1165 Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,

28. International finance 120181-1165 Opracowanie własne na podstawie P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,

29. International finance 120181-1165 The Barro-Gordon model  Monetary policy credibility analysis after establishing a monetary union  Rational inflation expectations  U-Un=α(Лe-Л)

30. International finance 120181-1165 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

31. International finance 120181-1165 The Barro-Gordon model Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,

32. International finance 120181-1165 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

33. International finance 120181-1165 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

34. International finance 120181-1165 The advantages of creating a monetary union Source: Own elaboration based on: de Grauwe, op. cit

35. International finance 120181-1165 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

36. International finance 120181-1165 The comparative OCA approach Source: Own elaboration based on: de Grauwe, op.cit.

37. International finance 120181-1165 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

38. International finance 120181-1165 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)

39. International finance 120181-1165 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

40. International finance 120181-1165 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

41. International finance 120181-1165 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

42. International finance 120181-1165 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

43. International finance 120181-1165 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

44. International finance 120181-1165 References  P. De Grauwe, Economics of monetary union, Oxford University Press, 2007.  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