Economics of Monetary Union
Course material:
- Book  Economics of the Monetary Union, Oxford University Press, Degrauwe, P (2020).
- Slides on Toledo
- Research articles, some are compulsory reading & serve as references for tables/figures used in the slides.
Exam: written, open questions (argue well) and closed book. Exam questions at end of each chapter.
Chapter 1: The Costs of Common Currency
In a monetary union (MU) a country loses its ability to conduct a national monetary policy to deal with
asymmetric shocks. It is a common currency so monetary policy is delegated to a common central bank.
You can’t select interest rates anymore which also effects the value of your currency. Therefore, there is no
tool to stimulate private investment. You are depending on what the EBC will do.
There are other costs due to:
-
Vulnerability of government to liquidity crises.
It changes how a national government finances its deficits. 2010 crisis showed that loss of monetary
independence also means a national government cannot give 100% guarantee to national bond holders that
when the bonds comes to maturity that it will have the liquidity to pay it back. Cannot give guarantee as the
amount of liquidity in your national money market is defined by someone else (the ECB).
-
Differences in labour market institutions.
Differences in legal systems.
A Symmetric shock in the Euro Zone (recession everywhere) can cause labour markets to react very
differently, causing deeper recessions in certain locations
Shifts in Demand (Robert Mundell 1961, Nobel winner)  analysis: Theory of optimum currency areas
Assume 2 countries, France & Germany.
First, case of a symmetric shock.
Common central bank can deal with these
shocks, the reaction from the central bank will be
good for both countries. MU is more attractive
than beggar-my-neighbour policies under
monetary independence.
Assume there is a recession in both countries:
Second, asymmetric shocks.
In a MU, not in a MU = monetary independence.
Example: decline in aggregated demand in
France and an increase in aggregate demand in
Germany. A permanent shock due to change in
consumer preferences (<> temporary shock).
The central bank cannot deal with this, because whatever it does it will leave someone unhappy. Suppose it
adopts a expansion monetary policy, that would be good for France but not for Germany who is already
suffering from inflation. If they were to adopt a restrictive monetary policy, that would be good for Germany
but that would push France into a deeper recession.
In a MU: common central banks cannot deal with these shocks.
Ex: reunification East-West Germany in 1989 and restrictive monetary policy Bundesbank during EMS.
- MU will be costly unless there is wage flexibility and labour mobility in that monetary union.
Wage flexibility 
- Unemployment in France reduces wage claims in France, aggregate supply in France shifts downwards.
- Excess demand for labour in Germany raises wage claims in Germany.
- Aggregate supply in Germany shifts upwards.
- Second-order impact on aggregate demand:
Wages impacts prices and product prices
impact competitiveness. Real income impacts
private consumption.
Labour mobility 
French unemployed move to Germany.
However, this is very limited in Europe
especially for low skilled workers.
Countries that are not in a MU:
It depends on exchange rate regime 
1. Flexible exchange rate regime: France lowers interest rate, Germany raises interest rate 
depreciation of the French franc with respect to Deutsche mark  AD curve increases in France and
decreases in Germany.
2. In AD-AS model. And in IS-LM model?
Monetary Independence and government budgets 
When countries join a MU, it reduces their capacity to finance their budget deficits, they become vulnerable
to distrust of financial investors.
UK Scenario: supposes investors fear default of UK government. They sell UK government bonds (the price
goes down), interest rate increase (they require a risk premium in order to invest), proceeds of sales (in
pound) in forex market and the pound depreciates.
- UK money stock, controlled by BoE, remains unchanged.
- Part of this money stock/pool of liquidity will probably be reinvested in UK govt securities. If not Bank of
England can be forced by UK government to buy UK government bonds, to provide liquidity to pay out cash
to holders of government bonds.
- Investors cannot trigger liquidity crises for UK government and thus cannot force default, so they will not
try to do so.
Spanish scenario: suppose investors fear default of Spanish government. They sell Spanish government
bonds, interest rate increases, and proceeds of these sales (in euros) are used to invest in other eurozone
assets. Portfolio reallocations within the euro are sovereign bond asset class.
- No floating exchange rate to stop this
- Spanish money stock declines, pool of liquidity for investing in Spanish government bonds shrinks
- Liquidity crisis possible, Spanish government cannot guarantee to pay out cash to government bonds
holders and cannot force the ECB to buy Spanish government bonds.
- Financial investors know this and can force default on these countries.
- Spain’s situation is similar to that of emerging economies that have to borrow in a foreign currency.
- A sudden stop of capital inflows.
The Spanish government became insolvent not because of the debt ratio but because the nominal interest
rate went up so much that this condition wasn’t satisfied anymore:
Asymmetric shocks and debt dynamics
Interaction between asymmetric shocks and debt dynamics: Ex:
- Negative shock in France increases budget deficit in France (due to automatic stabilizers), and positive
shock in Germany increases budget surplus in Germany.
- If markets lose trust in French government’s solvency, asymmetric shock is amplified in France&German
If investors fear that French government will be unable to pay back, investors will sell French gov bonds
meaning the price will go down and the interest rate will increase (& will require a high interest rate risk
premium). And that can lead to a liquidity crisis in France (Less C + I = AD France further to the left). But this
will also impose austerity on the French government.
The automatic stabilizer effect is not a policy, it happens automatically. But because of the liquidity crisis,
the French government is also forced to undertake restrictive monetary policies, and as a consequence the
AD curve will shift further left.
Secondly, because private consumption and investments will be affected. In France the long-term interest
rate of the government bonds will increase, but that will also have an impact on the interest rate that French
private banks require from their clients.
In Germany the opposite happens. First we have the automatic stabiliser effect that leads to budgetary
surplus, tax revenues increase, unemployment spending decreases… So the German bond will be considered
as a very safe bond, so the Germany government can invest under very cheap conditions. And you have the
same affect in the private markets, there is so much liquidity in the Germany banking system so they will
give very cheap loans to German consumers.
- Interest rate in Germany declines (more C + I = AD Germany further to the right).
Interest rates
 different types, interest rate depends on maturity (short or long-term asset)
depends on whether the market considered it as a risky or safe borrower and corporate or mortgage
Shouldn’t interest rates be the same in a MU?
- Yes for short term interest rate set by ECB
- Not for interest rates on long term government bonds (risk premium)
Booms and Busts in a MU
Permanent Asymmetric shocks, f.e result of change in consumer preferences vs. Temporary Asymmetric
shocks, f.e result of unsynchronized movements in animal spirits/business cycle movements.
2 possible scenarios in a MU:
1. Investors keep trust in French governments capacity to service its debt (financial investors consider
French & German bonds as perfect substitutes)  willing to buy the extra French bonds at
unchanged interest rate (matched by decreased holdings in German government bonds). Capital
market has a stabilizing role.
- For solvency condition the nominal interest rates remains the same, but the debt ratio in France
will be higher than in Germany.
2. Investors lose trust in French government, sell French and buy German government bonds. Interest
rates increases in France, decrease in Germany and the capital market = destabilising role. There will
be higher nominal interest on French bonds and difficulties for the French government to satisfy the
solvency condition.
The following graph illustrates how asymmetric shocks are amplified by divergent movements in long-term
interest rates, during the Great Recession in the Eurozone.
In Ireland GDP increases a lot, the reason for this has to do with the fiscal treatment of multinationals that
locate their headquarters in Ireland and that generates these high growth rates, but if we look at gross
national income we would have a different outcome.
Monetary and budgetary union  MU can be fragile.
-
Asymmetric shocks: difficult adjustment problems, unless there is wage flexibility/labour mobility.
Adjustment problems worsen if MU-members are vulnerable to liquidity/solvency crisis, amplifying
the recession.
Costs of a MU are reduced by:
- Unlimited liquidity support for bondholders by central bank with respect to national governments (no
bailout clause was put into the Treaty of Maastricht upon request of Germany, and it says that no
government or the ECB can be forced to buy government bonds against their will).
- A budgetary union: 1) + 2)
1. An insurance mechanism with ex-post transfers (automatic stabilization without a deficit in
France/surplus in Germany)
Suppose that we have a European government that raise European taxes and pays out European
unemployment benefits. What this means is that if there is a recession in France and a boom in Germany,
there will automatically be more tax revenues in Germany that is used to pay out employment benefits that
benefit the French citizens (automatic stabilizing effect).
Consumption smoothing, nothing changes with the living standard in Germany (because there is a boom but
also taxation so there is no inflation), and at the same time in France the employed get benefits. This solves
the liquidity problem. However, there is moral hazard. The transfers reduce the pressure on the regions to
adjust (permanent transfers = political resistance).
Permanent cross-country differences in labour market performances are related to different labour market
policies and institutions (EPL, ALMP, bargaining institutions).
2. A protection against a liquidity crisis
Eliminates capital movements from one bond market into the other (from France to Germany), avoiding
liquidity crisis. However, it requires a high level of political unification/ transfer of national sovereignty in
field of taxation/spending to European government, no there is no political willingness to do so.
- MU without a budgetary union = incomplete MU
- MU with a budgetary union = full MU
This how it works in the US, they have one central bank policy, but they also have a budgetary union.
Private insurance systems 
Budgetary union: public insurance.
Financial markets: private insurance.
Assume fully integrated equity & bond markets. French hold stock/bonds of German firms and Germans hold
stocks/bonds of French firms. Advantage: a shock in one country changes stock/bonds prices of firms in that
country, but resulting income change is shared by asset-holding residents all countries.
Reducing moral hazard & Avoiding amplification of shock.
However, insurance mainly for small group of wealthy
citizens.
Other sources of asymmetry that make MU costly
1. Different labour market institutions:
- Divergent wage & price developments even for
symmetric shocks. Ex: supply shock, oil price rise
- Asymmetric impact on unemployment and
economic activity
Ireland & Spain: worst affected in 2009-2011 after consumption/property boom 2000-2006.
Spain: dual labour market of insider-outsider/young unemployed on temporary contracts, EPL older workers
Germany: unemployment fell between 2008-2011 (BUT decrease GDP by 5% in 2009), due to reforms
improving flexibility labour market (cutting hours, not workers) + restructuring manufacturing 2000-2005
UK: low unemployment partial due to decrease in real earnings after crisis + labour market flexibility reform
Example: differences in bargaining institutions across EU countries Bruno-Sachs(1985) Calmfors-Driffil (1988)
-
-
Centralised bargaining internalizes impact of wages on prices  no incentives for wage claims less
unemployment (Scandinavian countries)
At industry level: free riding when effect of union on aggregate prices is small  incentive for excessive
wage claims  more unemployment (Continental countries). If all unions reason in the same way it
does have an effect on inflation and on the economy.
Decentralized at firm level: in competitive market, union fears wage claims to be translated by firm in
higher consumption price on output market and consumers shift to other suppliers and job loss in their
firm wage moderation and less unemployment (liberal welfare states)
Different legal systems:
-
Mortgage market with different loan-to-value ratios, floating/fixed mortgage rates, …
Firms finance investment projects through:
a) Bond and equity market in anglo-saxon legal tradition
b) Banking system in continental legal tradition
Same interest rate change by ECB is transmitted into large/small consumption and investment spending
effects in Anglo-Saxon / continental MU-members
Chapter 2: The Theory of Optimum Currency Areas: A Critique
Critiques of OCA-theory can be formulated at 3 different levels:
1. How relevant are the differences between countries?
Is a demand shock in one MU-member a likely event?
European Commission View 
- Most intra EU trade is intra-industry. Ex: France sells cars to and buys cars from Germany and vice versa.
- Trade Integration leads to less asymmetric shocks. Ex: a shock on the demand for cars will equally affect
demand for Mercedes and Renault.
Krugman view:
- Trade integration leads, due to economies of scale, regional agglomeration & inter-industry trade. Ex:
automobile industry may be concentrated in Germany. Sector specific shocks may be country-specific shocks
- Trade integration leads to more asymmetric shocks.
Which view is more likely to prevail?
About the relationship between trade integration and symmetric shocks: trade integration leads to
concentration in regions, but region-specific does not mean country specific. Empirical evidence:
-
Trade integration leads to more symmetric shocks.
Rising role of services (70% GDP), less subject to economies of scale  trend towards regional
concentration may stop.
There is no evidence of more regional concentration today than in 1991 in EU automobile industry,
contrary to Krugman’s expectations.
About the relationship between MU-membership and trade integration: Rose (2000), but it was heavily
criticised (see section 3.5)
Did joining a MU change the behaviour of labour unions?
- EC Report (1990):” a credible MU will affect the behaviour of wage-bargainers. They will be more careful
about risking becoming uncompetitive, given that devaluation will not be an option”.
Theoretical model of wage bargaining:
- Convex indifference curve of the labour union
- Negatively sloped demand for labour curve:
a) Centralised or decentralised, flat labour demand = high employment.
b) Industry level: steep labour demand = low employment.
- However, there is no empirical evidence that being in a MU makes WS curves similar.
Deriving wage setting curves for different institutional arrangements
Different legal systems and financial markets 
Did joining a MU lead to similar functioning financial markets? There was more financial integration but
there are still differences in the legal systems. Ceteris paribus, since MU, less differences in inflation and
therefore in maturity structure government bonds.
- However, since sovereign debt crisis eurozone, differences in government bond yield, not due to inflation
differences but due to different risk premiums => again differences in maturity of bonds.
2. Is national monetary policy (including exchange rate policy) effective?
Permanent demand shock: changes in relative prices necessary to go back to initial output.
A: situation after permanent demand schock in France
- National monetary policy leading to a depreciation: demandcurve shifts back to F (intial outpout and price levesl before
the demand shock).
- In F: due to the increase in price of imported good, increase
in production cost and reduction real wages >> Supplt curve
shifts to f’ depending on openess economy, wage baragining,
institutions labour + product market.
- In short term, nominal depreciation leads to temporary real
depreciation from A to F.
- However in the long run, real exchange rate increases again
if upward pressue on wages/prices cannot be resisted in labour markets.
Adjustments needed in a MU and withouth a MU:
In a MU, the permament negative aggreage demand schock must be followed by a nomial wage
decline/downward shit of aggregate supply curve >> declien real wages in France
Withouth a MU, when the government reacts to the permanent negative demand schock with a
depreciation the upward pressue on the nominal wage must be resites >> delcine real wages in France
Whatever the monetary regime, Frenh workers
must accept a decline in real wages; difficult to
achieve in both regimes.
See Blanchard et al;(2013) : Latvia (in ERMII) did
not devaluate, but successfully chose for
internal devaluation < > PIIGS : internal
devaluation rather unsuccessful
- Latvian Prime Minister, when asked in 2013 how he convinced all social partners to accept massive wage
cuts: “To get into the eurozone you do anything. Once in, you can evidently do whatever you want”.
Budgetary implications of these adjustments 
Greece, Spain, Italy (in a MU):
-
At the zero lower bound interest rate(ECB), reduction nominal wages and prices  increase real
interest rate for borrowers  increase budget deficit  vulnerable to liquidity and solvency crisis
The reduction in wages was not fully
translated in reduction in prices: no
productivity gain
Latvia/Lithuania: internal devaluation
announcement frontloaded austerity  decrease
risk premium and low interest rate for borrowers
 decrease budget deficit.
In a MU: the common central bank account solve the problem:
- If it lowers the interest rate to alleviate the French problem, it increases inflation in Germany.
- If it rises the interest rate to counter inflation in Germany it intensifies the recession in France.
- Because governments have no control over debt issuance, this can lead to liquidity and solvency crisis.
Without a MU, national monetary policies can stabilize output at national level.
- French central bank can stimulate AD by reducing interest rate & allowing French Franc to depreciate.
- German central bank can raise interest rate and allow the Deutsche Mark to appreciate to dampen AD.
Conclusion: monetary policy not effective in long term, only in the short term -> cost of a MU is only
relevant for the short term, not for the long term.
3. How credible are national monetary policies?
The reputation (or credibility) of a government in pursing an announced police has a great impact on the
effectiveness.
Barro-Gordon model: a geometric intr.
It explains the relationship between unemployment and inflation. Unemployment on the horizontal axis and
inflation on the vertical axis.
- If inflation = expected inflation, then unemployment will be = to natural unemployment (and vice versa)
- If unemployment is less than the level of natural unemployment we are in a situation where inflation is
higher than the expected inflation.
Shot term means for a given expected inflation, a medium term you know that the price expectations will be
adjusted. So, in the short term you can look at a Philips curve for a given expect inflation. What can happen
with a shot-term trade off is that governments push unemployment below natural level of unemployment.
The vertical lines is referred to as the long term Philips curve, and it is vertical because it means in the long
run we will be at the point of this vertical line. So, even though in the short term you can do all sorts of
aggregated demand curves, in the end we will be somewhere on this line (and you can chose between the
levels of unemployment and inflation).
The preferences of the authorities 
The slope of this indifference curve, expresses the relative importance that the governments attach to
fighting inflation or fighting unemployment.
- Hard-nosed government attaches a lot of weight to fighting inflation (accept a bit more unemployment)
- Wet government attaches a lot of weight to fighting unemployment (accept a lot of additional inflation to
reduce unemployment).
The equilibrium inflation rate 
Point A is preferable to point E.
- Politicians evaluate the short-term gain from cheating against the future losses that result from the fact
that the phillips curve shifts upwards
- But only point E can be sustained as an equilibrium given that authorities are short-sighted and that the
private sector knows this. The next election is never far away >> independency central bank wrt politicians
- In a repeated game, lower inflation equilibrium is possible if govs acquire a reputation for low inflation
Equilibrium with hard-nosed & wet governments
The Barro-Gordon model in an open economy  Assume Germany is hard-nosed & Italy a wet government
Without a MU: Purchasing power parity condition: if inflation is higher in Italy than in Germany, the Italian
lira should depreciate wrt Deutsche Mark:
e  p I  p G
Italy has a high and Germany a low inflation. Italy could achieve lower inflation, if once at point F, it could
convince citizens not to try to reach point G
Inflation equilibrium in a 2-country model
In a MU: point F becomes a credible low inflation equilibrium for Italy = strong argument to join a MU!
- Assumption: central bank is the hard-nosed German central bank
- Cfr. latin american countries / dollarization
Cost of MU and openness  Effectiveness of currency depreciation as a function of openness
1. A same depreciation leads to:
- Higher increase in aggregate demand in relatively open (f.e. export=99%GDP) than closed (f.e.
export=1%GDP) economy
- Higher upward shift in aggregate supply in relatively open than closed economy (because more
impact of price imported goods on CPI and wage-price spiral)
2. More trade integration makes asymmetric shocks less likely (=european commission view)
Conclusion of 1) + 2) together : cost of a MU most likely declines with the degree of openness of a country.
The cost of a MU and the openness of a country 
Chapter 3: The Benefits of a Common Currency
The cots of EMU: macroeconomic management.
The benefits of EMU: are microeconomic gains in efficiency,
-
Elimination of transaction costs
Elimination of risks for firms’ revenues coming from volatile future exchange rates
Potential of an international currency
Direct gains from the elimination of transaction costs 
-
Eliminates cost of exchanging one currency (banknotes, coins) into another  elimination
deadweight loss=efficiency gain
a) Empirical evidence is scarce. Cost savings = 0.25 to 0.5% of GDP (EC(1990)
-
Target integrated payment system for real-time cross border payments between banks. Since 2010,
major imbalances in TARGET: southern Eurozone countries, with current account deficits, face
liquidity outflows matched by claims of northern Eurozone countries for liquidity inflows.
a) It allows payments to be done in a quick and efficient way.
Indirect gains from elimination of transaction costs: Price transparency 
-
Transparent price comparisons  competition  convergence & consumers should gain.
However, there are price differentials of identical products in eurozone
Evolution of price convergence stopped since Eurozone. Why?
a) Geographical distance
b) National advertising, customs/culture/language
c) Differentiated (electronic) products, without Eurozone, price differentials would’ve been higher
d) Different labour costs?
- Price transparency as a trigger for integration in other areas. Biggest gain from the Euro isn’t the price
transparency but that this price transparency can act as a trigger for further reforms in the financial
markets, harmonization’s of the legal systems, legal rules about mortgages, corporate finance, etc.
Gains for trading firms from less uncertainty 
-
Eliminating the exchange rate risk reduces uncertainty and ceteris paribus increases firms’ revenues
A risk-averse firm is only prepared to take risk if it leads to a higher average return
Suppose a price-taking firm (perfectly competitive market) that exports its whole output:
- Exchange rate is fixed  price p1  profit= (p1-mMC)*q)
- Exchange rate fluctuates  price fluctuates between p2 and p3 > profit is on average higher under
uncertainty than in certainty regime
However, exchange rate changes are not normally distributed, there’s a tails risk: distribution that is highly
skewed & it means that lower probability of a disaster & a high probability of a normal period.
With sufficiently large price movements, firms could go bankrupt, if price below the marginal (and average)
cost curve. Large exchange rate movements are a recurrent problem with floating exchange rates but also
during EMS in early 90’s (period of create turbulence)
- Creating large adjustment costs
- Difficult to manage in a world of free capital mobility
- Increasingly seen as source of asymmetric shocks
Exchange rate uncertainty and economic growth 
Another important argument that was advanced by the European Commission in its reports to convince
policy makers of the benefits of entering a monetary union is this: the elimination of the exchange risk would
lead to a permanent growth of economic growth in the long run. The idea was that the elimination of the
exchange rate uncertainty would lead to less systemic risk for private investors – it would lead to a lower risk
premium. When the risk premium decreases, they would face a lower interest rate when they want to
borrow to finance investment projects.
The neoclassical growth model tries to explain the determinates of growth of GDP in the long run, and it says
that in the long run the trend increase in GDP that we observe since the end of WWII is due to accumulation
of capital (physical capital, investments in human capital). The part of the trend increases in GPD that cannot
be explained by accumulation of capital could perhaps be because of technological progress.
The different elements of this model:
-
-
Neoclassical growth model: Production function per capita (capital and labour) Y/L =y = f(K/L) =f(k)
a) Diminishing marginal productivity, it means that if we add an additional input in the production
process that output will increase but a decreasing rate.
b) Constant returns to scale where λ=1/L: If Y=f(K,L)  f(λK, λL) = λ f(K,L), it means that if all inputs in
the product process are multiplied by the same coefficient then output will also be multiplied by the
same coefficient (will grow proportionately)
Depreciation of kapital stock per capita k at rate δ
Private savings S = sY = sf(k)
Steady state (k*, y*): sf(k)= δk
a) Growth rate of output per capita and capital per capita growth rate is only positive if population
grows or technological change
Golden rule = specific steady state where consumption C = f(k) – sf(k) is maximized < = > f’(k) = δ
In a perfectly competitive economy: firms choose production factors so as to maximize profits  first order
condition: marginal product of capital = price of production factor capital: f’(k) = r
Equilibrium (k*,y*): point A where interest rate that consumers use to discount future consumption equals
marginal productivity of capital => Figure 3.5.
Return of capital may be uncertain and contain risk premium. Elimination exchange rate risk  reduction
systemic risk  lower real interest rate r, lower risk premium  k must increase in order for f’(k) to
decrease to the lower level of r  temporary increase growth rate  higher y* and k*
Neo-classical growth model:
The marginal product of capital (the slope of the production function) will be equal to the real interest rate
in the capital market, and that is given by the slope.
The effect of lower risk in the neoclassical growth model 
Based on the assumption of the European Commission that the real interest rates faces by private investors
will decline, and will lead to increased investments. It also means that the marginal product of investment
decreases. It means we shift from A steady state to B steady state, and that leads to economic growth. But,
to temporarily positive growth rate while what the European Commission predicted is that would be
permanent (so something is lacking).
From exogenous to endogenous growth models 
Endogenous growth models are models that also try to explain the part of growth that cannot be explained
by the accumulation of capital alone, then we come to technological change. You also have endogenous
growth models that deviate from the assumption of constant returns to scale.
Productivity of labour increases during capital accumulation, leading to economies of scale:
-
Learning effects and accumulation of additional knowledge increase labour productivity over time
Knowledge: public good, freely available to the worker who uses a new machine
 f(k) shifts continuously upwards
Figure 3.8:
- No decline of the real interest rate in the Eurozone. Only in the catching up countries like Ireland, Spain,
Greece, more growth; but not result of increased productivity + undone since sovereign debt crisis.
- Empirical search: mixed results, difficulty in estimating counterfactual.
Impact of monetary union on trade: empirical evidence is weak 
Time series analysis of bilateral trade flows on exchange rate variability: weak and insignificant
-
Rose (2000) on basis of cross-section: “EMU increases trade flows by 200%”
Microeconomic sectoral analysis: EMU increased trade by 5-15%
Glick-Rose (2015): “no substantive effect of EMU on trade flows”
Benefits of an international currency 
1. Additional revenues for the central banks. The more money is issued and increases the size of the
balance sheet of the ECB
2. The use of a currency as international reserve by foreign banks, mostly under from of government
bonds, crfc. China – US. The Chinese bought a lot of US bonds to sustain the value of the dollar
against the Chinese currency.
3. Boosts activities of financial institutions in the domestic MU.
A final benefit of entering a monetary union could be that the currency of a large monetary union can
become an international currency.
Chapter 4: Costs and Benefits Compared
Benefit curve is upward slopping, it means the benefit of entering a monetary union increases with the
trade integration. Costs are downward slopping because more trade integration leads to asymmetric
shocks). And if we are not in a monetary union than the use of a national currency and national monetary
policies comes with a cost – price variability (it is higher when you have a very open economy compared to if
you have a very closed economy).
Cost schedule depends on the effectiveness of national monetary policies  At the time the EU was
created, the dominated view was the monetarist view.
The Monetarist view: national monetary policies are ineffective instruments to correct for asymmetric
shocks. Expansionary monetary policies lead to:
- Inflation without positive impact on real economy
- Credibility loss (barro-gordon model).
They consider that it’s not the task of the Central Bank to undertake monetary policy, it is the wage, prices
and labour mobility that is the mechanism that you should use & promote to deal with asymmetric shocks.
- Monetarists believe that the cost curve is close to the origin  small probability that joining a MU is costly.
The 'Keynesian' view: starts from idea that the labour market is not flexible, & the product market is not
flexible – wages & prices are rigid. National monetary policy is effective to correct for asymmetric shocks
- AD management can reduce unemployment, at least in the short run
-Wages and prices are rigid and/or labour is immobile
The cost curve far away from the origin  high probability that joining MU is costly
Early 80s: in the after match of the oil crisis these West European countries faces stagnation, so wages prices
spiralled and high inflation. So that is why the monetarist view became very popular (=EC view).
Since sovereign debt crisis in 2010: there was a comeback of the Keynesian view and at the same time we
see that in a lot of countries in the Eurozone citizens became reluctant to the idea of these structural
reforms – so a loss of popularity of EMU (in some countries, ex Italy, Greece, France): Eurobarometer.
Degree of trade integration in EMU
Labour mobility 
Asymmetric shocks and labour market flexibility 
Symmetry: degree to which output/employment growth are correlated.
Mundell trade-off (between symmetry & flexibility): low degree of symmetry in output growth need to be
compensated by lot of flexibility for a MU to be beneficial for a region.
- Downward slopping OCA-line = minimum combinations of symmetry and labour flexibility that a region
must have for a MU to be beneficial.
Conclusion form empirical studies 
-
Empirical assessment of intra-EU trade, degree of asymmetry of shocks, degree of labour flexibility,
degree of completeness / budgetary union, degree of effectiveness of national monetary policies
EU-15 (& EU-25) is not an OCA: a MU involving all 15 (or 25) EU members is economically a bad idea
Core-periphery view: there is a minimum set of countries for which MU is optimal: Germany,
Benelux, Austria, France.
US is likely to be an OCA because labour flexibility is higher in US than EU
Labour flexibility is higher in East-European countries than eurozone countries
The challenging task for the EU-25 is to move to the other side of the OCA-line, to make a MU less costly.
How?
- Reduce degree of asymmetry of shocks
- Increase degree of flexibility of labour markets  reform of labour markets institutions is necessary
Labour Unions and MU 
In case of asymmetric shocks, wages should be flexible:
- If different growth in productivity between regions, nominal wage growth should reflect regional
productivity differential.
- Centralized bargaining  unemployment differential between regions ex: West/East Germany,
North/South Italy, Flanders, Wallonia. Imposing a centralized bargaining scheme when there are
underlying differences in productivity in the regions, you cause structural unemployment in the
region with the lowest productivity.
In case of symmetric shocks:
- Different bargaining systems, if there is a different employment impact = argument for a uniform
bargaining system (uniform is not the same a centralised)
- Wage flexibility is necessary
The degree of completeness of a MU 
In an incomplete MU (without budgetary union)
asymmetric shocks are likely to be amplified.
- This shifts the cost curve to the right  being in an
incomplete MU is, ceteris paribus, more costly.
If you have a monetary union which is also a
budgetary union, we call this a full monetary union.
When we have a budgetary union, it means it becomes easier in case of asymmetric shocks. Ex: if there is a
recession in France and a boom in Germany, it means tax revenues from Germa residents are used to pay
out unemployment benefits in France, and that limits the asymmetric of the shock and it avoids the risk of
liquidity crisis and problems of distress in the financial markets.
Costs and benefits in the long run 
The question is to what extent can the very act of joining a Eurozone speed up trade integration, lead to less
asymmetric shocks and therefore make it more likely that we have an optimum currency area?
Downward sloping line (OCA) in symmetry-trade integration model:
Combinations of minimal symmetry and trade integration for a MU to be beneficial. A common currency will
lead to less transaction costs and that will speed up trade integration and this will lead to less asymmetric
shocks.
- Both integration and symmetry reduce costs of a MU  a reduction in symmetry must be compensated by
more integration to make a MU beneficial.
- Upward sloping line (TT) = EC View
The EC view of monetary integration:
The Krugan view of monetary integration:
OCA: optimal currency area line
This will eventually bring us into the optimal currency area.
Krugman said that when you increase trade integration, first it will concentrate activities in a specific region
and when there is a shock it will enhance asymmetric shocks. So when trade integration increase the degree
of asymmetry of shocks will increase, so that why you have a downward slopping line.
The Krugman view offers two possibilities:
1) Flat downward-sloping TT line: Although today the EU-25 may not be an OCA, it will move into the OCA
zone over time
2) Steep downward-sloping T’T’ line: Integration brings us increasingly farther away from the OCA zone.
The net gains of a MU do not increase fast enough with the degree of integration : very implausible
Conclusion: whatever (EC view or Krugman view), even if trade integration leads to asymmetric shocks, it
may bring us closer to OCA-line
Frankel-Rose (1998): “A decision by a country to join EMU, even if it does not satisfy the OCA criteria at that
moment, may speed up integration and move the country into OCA-zone”
Is there any evidence of Endogenous nature of OCA criteria in Eurozone? There are mixed results, and it is
difficult to analyse.
- Trade integration? Econometric evidence
- Symmetry? They look at the correlation coefficient.
Descriptive statistics, econometric analysis:
a) Williams-Vijverberg (2018): “point to the importance of reforming before joining the euro and not
expecting the act of joining to bring the desired economic changes”
b) Campos et al.(2020): joining eurozone increases correlation from 0.4 before 1999 to 0.6 since 1999, more
in core than in periferi
-
Labour flexibility?
a) Generosity of unemployment benefit scheme
b) Flexible hours arrangements
c) Union dentisty, level of bargaining
d) Indicator of labour mobility: gross migration rates
There is no evidence that joining the EU changes the behaviour of labour unions
Indicators of labour market rigidities:
There is a change in 2010 with the sovereign debt crisis, and the
political deal to save Greece and Spain we impose labour market
reforms in some countries – making the labour market more
flexible.
Is Latin America an OCA? 
Fixed exchange rates were fragile due to current account + budget deficits  speculative attracks on
foreign reserves in central banks. This leads to devaluation and inflation. To overcome this credibility
problem in some countries they adopted the fixed exchange rate regime, where the pegged the peso to the
US dollar. This is not enough to solve the problem, if you do not simultaneous form the economy.
1. Level of trade integration: there is a low intra-regional trade, though trade openness as a region is
relatively high (when they trade they do so with the US not among themselves).
- Trade openness = exports + imports/ GDP
- Intra-regional trade) = (intraregional export + import) / (total export + import of the region)
2. Exposure to asymmetric shocks is relatively large and asymmetric shocks tend to be large.
- Economic structures (share of agriculture, industry, services) are very dissimilar.
- Latin American countries have a relatively high degree of specialization compared to US and EU
(where it is a more diversified economic structure).
- Differences in GDP level and growth rates, also within regions under trade agreement
3. Degree labour market flexibility seems low: it refers to labour mobility and wage flexibility
- Labour market = sum of outward + inward residents per thousand residents of a country or region.
It is low: 6 out of 1000 residents moves to another country per year comparable to the low labour
mobility of EU-countries: 6 per 1000 (2012). It is much lower than the labour mobility in US: 15.5 per
1000 residents, distributed equally amongst US regions (2012)
- Existence of segmented labour markets
4. Unlikely that MU in Latin America would bring price stability: they don’t have the labour flexibility
that is needed in case of asymmetric shocks.
- Cfr Barro-Gordon Model
- There are no central banks in Latin America with a good record on inflation. Uncredible that a
single Latin central bank, that represents Latin American countries, could be created with good
reputation on low inflation.
- Dollarization would be credible, however there would be a strong political resistance.
The conclusion is no.
Is East-Asia an OCA?  Fixed exchange rate regimes in a world of capital mobility led to Asian financial crisis
in 1997-1998, so came the idea of a MU in East Asia.
- East Asian countries such as Taiwan, Vietnam, Singapour…
Economic conditions for MU is East Asia seem to be better satisfied than for the Eurozone, trade integration
is higher - there is a high level of intra-regional exports of goods and services in East-Asia.
- There are no more asymmetric shocks than in eurozone countries.
- Labour markets are at least as flexible as in the Eurozone.
However, there are large cultural differences – the decide for political unification is week.
- Since the end of WWII, process of political unification in Europe (EC, ECJ, EP), customs union since 1968,..
 creation ECB was “relatively” easy.
Monetary Unions in Africa  There are 3 monetary unions in Africa
-
-
West Africa regional integration initiatives ECOWAS (the aim is economic union).
WAEMU (West African Economic Monetary Union) is a combination of countries that were former
French Colony. It was pegged to the French Franc currency until it was replaced by the Euro.
a) These countries became independent in the 50s and 60s but they still have a central bank where
the French government has a sort of veto power, and also the assets from the central bank have to
be invested a minimum amount in French bonds.
Since 2000, the non WAEMU-members agreed to form a second MU, the WAMZ (West African
Monetary Zone) by 2020.
The WAMZ and WAEM would merge by 2020 to make of the common market a westafrican EMU. So
far it has not been done.
Is ECOWAS an OCA?
When using the Eurozone as a benchmark, the evidence on the 3 OCA-criteria is mixed:
-
-
The degree of trade integration among West African countries is very low, intraregional exports are
very low. One of the reason is because the obstacles to trade are very hard, its hard to cross the
borders – they are many formalities.
The degree of flexibility: labour mobility is substantially stronger in West Africa
Degree of asymmetry does not seem to be larger in West Africa than in the Eurozone
Economic conditions not satisfied, but political willingness. WAEMU already set into place institutions, such
as a common central bank  although west-African MU is not an OCA, it seems sustainable.
Note: for the moment we cannot say that the Euro is an optimal currency area.
Chapter 6: The Transition to a Monetary Union
The Maastricht Treaty  it was signed in December 1991 in the Dutch city of Maastricht; it is considered the
blueprint for the Eurozone. The process towards MU in Europe was based on 2 principles:
1. The transition towards MU in Europe = gradual
2. Entry into the MU is conditional on satisfying convergence criteria
Convergence criteria, for each candidate country:
1. Inflation rate, it defines the best performing countries in the eurozone. It says each candidate
country should display inflation rates that is less than the average of the 3 lowest inflations rates in
the group of candidate countries plus a margin of 1.5%
2. Long-term interest rate, average observed in the 2 low-inflation countries plus a margin of 2%
3. Exchange rates, joined the EM and didn’t experience a devaluation during the two years preceding
the entrance into MU
4. Government budget deficit, it shouldn’t exceed 3% of GDP.
If this condition is not satisfied, it should be declining continuously and substantially and come close
to the 3% norm, or the deviation from the 3% should be exceptional and temporary
5. Government debt, should exceed 60% of GDP.
If this condition is not satisfied, it should ‘diminish sufficiently & approach 60% at satisfactory pace’.
It became clear that countries like Belgium, France & Italy would never be able to satisfy these budgetary
criteria, so they relaxed the criteria such that Belgium, Italy and France could join (the ifs). It was relaxed in
1997 when they created the Stability and Growth Pact.
To make UK sign, it obtained the right to opt out of the eurozone + social chapter (it states working
conditions, social dialogue, etc). After Treaty-signature, ratification by national parliaments. In some
countries it is compulsory to organize a referendum on these matters before the national parliament can
ratify such a treaty: 3 countries (Denmark, France, Ireland),
-
Ireland: 69.1% in favour
France: 50.8% in favour
Denmark: 50.7% against, Denmark obtained expectations (no eurozone – they have a fixed exchange
rate with the Euro, opted out of migration policy, justice, and defence) and there was a second
referendum in 1993 and 56.7% were in favour.
In the UK, difficult ratification by parliament: Internally divided conservatives  catalyst for Brexit vote. This
on top of the 2 outcomes of the referendums of France and Denmark (weak support) and this led to
speculation of the British pound and led to Black Wednesday. The consequence of it immediately suspended
their participation in the fixed exchange rate mechanism (ERM) and the pound dropped in value.
In 1998: 11 EU-countries were allowed to enter the eurozone: Austria, Belgium, Finland, France, Germany,
Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain.
- Sweden decided not to join, it refused to enter the exchange rate arrangement to intentionally failing to
satisfy one of the entry conditions.
- Greece did not satisfy the criteria in 1998 but falsified the budgetary numbers to join the eurozone in 2002.
- Denmark, Sweden, UK satisfied the criteria but decided to stay put of the Eurozone.
Since 2007: new eurozone members of central/east Europe, Slovenia, Cyprus/Malta, Slovakia, Estonia,
Latvia, Lithuania.
- National central banks still exit but don’t take independent decisions anymore/execute ECB decisions.
- Supervision of non-systemic banks.
Why convergence requirements? 
OCA theory stresses micro-economic conditions for a successful MU:
- Wage and price flexibility
- Labour mobility
- Symmetry of shocks
- Budgetary union
If satisfied, no need for Maastricht criteria. If not satisfied, it is not a good idea to allow for a MU, even
though Maastricht criteria are satisfied. However, it is not because you satisfy these criteria that it
automatically implies that it is an interesting economic idea to create a monetary union. Maastricht Treaty
stresses macro-economic converging outcomes:
-
Inflation
Interest Rates
Budgetary policies
Inflation Convergence 
Before EMU: Germany and Italy are assumed to have the same natural unemployment. Germany prefers low
inflation; Italy high inflation.
Vertical line stands for national unemployment, and it is the combination of all possible inflation rates with
the unemployment.
- There is a Philips curve, negatively slopped because it illustrates the short run trade-off between inflation
& unemployment.
- Size and shape of the indifference curve signals the relative importance that national authorities attach to
fighting inflation or unemployment.
- Germans are more in favour of low inflation and will expect more unemployment, while the Italians attach
more importance to low unemployment.
- The final long-term equilibrium that you will have with the German central bank will be different from the
final long-term equilibrium with the Italian central bank.
Argument: Germany would reduce its welfare by entering a MU with high-inflation countries if the ECB
reflects average preferences of inflation, leading to location between EI and EG
Germany would only join MU under the condition that ECB ensures low-inflation, like the Bundesbank. Highinflation candidate countries prove evidence of low-inflation preference = convergence criterium
Budgetary convergence 
Before EMU: Germany has a low debt-GDP ratio and Italy had a high debt GDP ratio. Argument: Germany
would reduce its welfare by entering a MU with countries with high debt-GDP ratios because:
1. Risk of future inflation. Interest rate of long-term bonds bases on low inflation expectations 
surprise inflation erodes real value bonds  in real terms Italian government gain & bondholder lose
2. Countries with a large debt face a higher default risk  pressure for a bailout in the event of a
default crisis
A low debt-GDP country would only join MU under the condition that high debt- GDP countries reduce debt
before entering the MU = convergence criterium.
Resulting requirement:
- Max 3% budget deficit + debt to GDP ratio of 60%
- No bailout clause: neither governments nor ECB can be forced to take over debt of other countries.
Derived from formula d = gb where:
-
b = level at which the debt to GDP ratio is stabilized
g = growth rate of nominal GDP
-
d = budget deficit of % GDP
Stabilization if change b per unit of time = 0: b = d – gb = 0
To stabilize debt at 60% GDP, deficit must be brought to 3% GDP, given nominal growth rate of GDP of 5%:
3% = 0,05*60%
The rule is quite arbitrary and inconsistent: If g=3%, 
1.8% = 0.03*60%
3% = 0.03 *100%
- Why 60% / 3% / 5%  > at the time of the Maastricht Treaty negotiation this was the average in the EU
- Romano Prodi (2003): “I know very well that the Stability and Growth Pact is stupid. We need a more
intelligent tool.”
Alternative story behind 3% deficit (ECB, 2019): President François Mitterrand was looking “for an easy rule,
that sound[ed] as coming from an economist, and [could] be opposed to the ministers that walk[ed] into his
office asking for money.”
They “came up with this number in less than an hour [...] without any theoretical reflection”. They were
looking for “something simple”, with a 1% of GDP government budget deficit being “too difficult to achieve”,
2% of GDP putting them “under too much pressure” and 3% of GDP being “a good number” that finally made
its way into French fiscal policymaking.
Exchange rate convergence (no-devaluation requirements) 
Argument: It prevents countries from manipulating their exchange rates so as to have more favourable
(depreciated) exchange rate in the union and a more competitive position (especially when joining – that’s
why the period last 2 years)
However:
- According to the Treaty, countries should maintain their exchange rates within the 'normal' band of
fluctuation during the two years preceding their entry into MU
- At the moment of signing the treaty: this ‘normal band’ was 2x2.25%
- Since August 1993, the 'normal' band was 2x15%
Italy left the Eurozone, and then came back in 1997 and then they spent 2 years without a devaluation, and
then they joined the eurozone again.
Interest rate convergence  later, it was easy to say it was irrelevant.
Argument: differences in interest rates prior to entry could lead to large capital gains and losses at the
moment of entry into EMU.
- We want to avoid that just before entry to the eurozone arbitrage on the capital markets.
Ex: before entry interest rate on zloty bonds (Poland) is 4% and on bonds in euro 2%. At the moment of
entry euro-zloty rate is fixed: no exchange rate risk  arbitrage: buying zloty bonds/selling euro bonds >
price of euro bonds drops/price zloty bonds increases (interest parity condition)
- Interest rate criterion is redundant, because of self-fulfilling expectations, once political decision is taken
How to organize relations between the ‘ins’ and the ‘outs’ 
- Eurozone consists of 19 out of 28 EU countries (27 without UK)
- EU-members (out of ERMII) with floating exchange rate: Sweden, UK, Poland, Czech, Hungary
- EU-members (in ERMII) with a fixed exchange rate: Denmark, Bulgaria, Croatia
ERM-II: it replaces the old Exchange Rate Mechanism since 1999.
- Adherence is voluntary for EU members.
- 3 members: Denmark, Bulgaria/Croatia(since July 2020)
- Anchor currency (the euro) + margin of fluctuation.
When the exchange rates reach the limit of the fluctuation margin, intervention is obligatory unless it would
conflict with the objective of price stability in the Eurozone or the ERMII country. However, it is unlikely that
ECB interventions would destabilize price levels in the Eurozone.
- Croatia and Bulgaria really want to join the Eurozone, but Denmark doesn’t.
Chapter 8: Political economy of destructing the Eurozone
Nowadays most EU policy makers seem to realize that the Eurozone is not an optimal currency area, we lack
the labour flexibility that is needed to deal with asymmetric shocks that we face. We have no budgetary
union to organize fiscal transfers between countries in the case of temporary asymmetric shocks, there is no
political willingness to do so, given the moral hazard risk that temporary fiscal transfers could turn into
permanent transfers.
The sovereign debt crisis in the Eurozone between 2010 and 2012, that led to the decision that the ECB
could buy an unlimited amount of government bonds of governments under attack, and at the same time
the political leaders imposed labour market reforms. During this period, the term Grexit was also on the
table. A possibility that was discarded, which suggests that the European leaders estimated that Grexit
would be a net cost for Greece and for the remaining Eurozone.
There are no provisions for exit in the Maastricht treaty, the only possibly to exit the Eurozone is to activate
article 50 of the Treaty (like the UK did). A state that activates article 50 automatically ceases to be a
member of the EU 2 years after the activation of that article. But the article 50 was not designed to be an
exit of a currency union.
Even though there are no legal provisions to leave the eurozone, if a sovereign nation wants to exit it cannot
be stopped from doing so.
If Greece and Italy where to leave the eurozone,
does that transform the Eurozone into an optimal
currency area? And is it beneficial for Greece and
Italy?
Greece  There is an issue with the quality of the
Greek macro-economic data. The Greek economy
experienced (after the start of the Eurozone) a
much stronger growth rate of GDP compared to
the average eurozone country. This boom in
economic activity is like the one that we observed in Ireland and Spain in these years. Unemployment rates
fell at the same time, from 12% to 8% (2008) but unemployment remains above the Eurozone average.
What is highly problematic is that despite the high growth rates, the Greek government was unable to
decrease its debt to GDP ratio. Greece was allowed to enter the eurozone with a debt to GDP ratio of 100%,
that is far above the convergence criteria of 60%. And there has been no decline of debt to GDP ratio. The
fact that this can happen, indicates that the Stability and Growth pact (which was supposed to be a
guarantee for budgetary discipline in nations states) is not enforceable or credible.
Aside from the fact that the Greek government doesn’t comply at all with the Stability & Growth Pact, what
happens is not normal (government spending clearly increased) – what you see is procyclical automatic
stabilizers. This is a missed opportunity, because entering the eurozone led to a strong convergence of the
Greek interest rates on government bonds towards the low German interest rates. Risk premium disappear
Another problem is the huge increase in Greek private debt. The Greek private sector owed massive
amounts of money. The money came mainly from coordination’s like Germany and the Netherlands, that
lend money to Greek banks that lend it to Greek consumers and firms, and that finally find their way to the
housing and constructing sector. So, the boom of economic activity was based on a massive inflow of cheap
money (with a low interest rate) lent out to Greek consumers and private firms.
The Real Interest Rate in Greece, Spain and Ireland was quite low and that is because inflation was relatively
high, while in German it was high, and inflation was low. The low interest payments translated into an
increase in real disposable income, which stimulates consumption and tended to drive up wages in a way
that harmed the competitiveness of these countries. It also led to trade deficit.
So, there was huge capital inflow, matched by a high current account deficit & while Greece has a current
account deficit, Germany & Netherlands have a current account surplus, & face huge capital outflow.
2008 there was the crash that effected the banking sector in the US and in Europe, that led to a decrease in
private consumption, investment, net export and aggregated demand in all European countries. In Greece
when the crisis began that meant that the capital inflows stopped (that effected the Greece commercial
banks). This forced Greek consumers & firms to reduce their spending such that the private debt declines.
All European countries were facing the same problems – the banking crisis. So national governments are
saving private, commercial banks and going into higher deficits – so an increase in the debt to GDP ratios.
In late 2009 that there was a new government elected in Greece and they disclosed that its government
budget deficit was much higher than it had initially estimated (and much higher than allowed by the stability
and growth pact). This made financial investors very cautious.
After the crisis of 2008:
- There were no more loans from Northern to Greek private banks or only at high interest rates,
forcing Greek consumers and firms to reduce their spending.
- Wages were cut to restore competitiveness (internal devaluation), reducing further spending.
- GDP collapsed; unemployment shot up to more than 25%
- Government debt exploded: automatic stabilizers
a) Selling of Greek government bonds with high interest rates in Greece led to a liquidity and
insolvency crisis. Greece forced to austerity  political unrest and popularity of extreme left/ right
political parties advocating for Grexit.
In 2015: government of Alexis Tsipras was voted with promise to end austerity measures & to keep Greece
in the eurozone (majority of Greek citizens wanted to stay in the eurozone but didn’t want to austerity)
He decided to organize a referendum on the take it or leave it proposal from the European Commission, and
he did that while the European policy makers warned him that if the proposal was rejected it would lead to a
Grexit, and it was rejected. Then several European governments called Greece to exit from the eurozone but
at the end Tsipras accepted a third bailout package (where the conditions were even harder than the
packaged that was rejected by the Greece citizens).
Italy Unfit for the Eurozone? 
Prior to eurozone, Italy used devaluations to restore competitiveness. Leading to frequent foreign exchange
crises and high inflation. but at least consistent with weak Italian institutions.
By entering the eurozone, Italy accepted to quit the tradition of devaluation to be able to restore
competitiveness. But to stay competitive you’ll have to improve your productivity, or another sort of internal
devaluation. But Italy did not take the opportunity to undergo structural reforms in the labour market or
reform industrial policies.
The living standards of Italian citizens today is lower than in 99 (at the start of the eurozone). The fact that
the GDP per capital now is under 100 means that Italy is doing even worse than Greece. Unemployment is
rather high in Italy, what is peculiar is that it increased since 2009 and since then remains high.
Their debt to GDP in 2017 is 130% which is more than double that is allowed by the Maastricht treaty. This
clearly demonstrates that the Stability and Growth Pact is not credible or enforceable. It is said that the
automatic stabilizers have to play the role during an economic recession to stimulate aggregated demand.
During a recession they automatic lead to a deficit, tax revenues go down and unemployment spending goes
up, but that argument cannot really be used in 2018 and 2019.
They suspect that in the Covid 19 crisis, Debt to GDP has increased to 159% in 2020 & 153.6% in 2021. The
share of Italian GDP (11%) in eurozone GDP is much higher than the Greek (as it is a smaller country – 1%).
The second big problem that they face is the competitiveness of the economy, since the start of the
Eurozone there has been a strong increase unit labour costs in the periphery countries (Greece, Spain, Italy,
Portugal). So, a decline in competitiveness which reduce net exports and leads to current account deficits
happened in all these Mediterranean countries.
What is important with respect to the decline in competitiveness is that in contrast to Greece, Spain and
Ireland (where the decline in competitiveness was driven by a consumption boom that lead to nominal wage
increases) in Italy the decline in competitiveness was driven by the decline in productivity (main in the sector
of construction and services).
- If Italy is unable to fundamentally reform its political institutions, it will be forced to leave the Eurozone.
The European leaders are not satisfied with the fact that Italy doesn’t show progress within the field of
labour market reforms and its competitiveness. But when you ask the Italian citizens on the opinion of the
eurozone, they are inclined to leave the Eurozone. The Italian elections in 2018 were won by 2 populist
parties that blame the eurozone for their problems.
Towards deconstruing the Eurozone 
Adjustment costs in Greece & Italy to asymmetric shocks were high + conditions (flexibility labour market,
budgetary union) for transforming Eurozone into an OCA are unrealistic.
- Many observers argue to allow Greece+Italy to leave the union and strengthen the remaining MU
- The cost – benefit analysis is necessary, that considers that the exit process itself may create costs.
Costs of deconstruction  ex: Greece, 2 costs:
1. If the Greek residents suspect at exit, there will be an attempt to transfer euro deposits held in the
Greek banks to Eurozone banks outside of Greece, because otherwise the euro deposits held in
Greek banks will be converted into drachme deposits and it will depreciate. So, there will be an
immediate capital outflow from the moment an exit is suspected. And if the Greek government
wants to stop this from happening it has to put in capital controls.
- There will also be restrictions on banknote withdrawals from Greek banks (to avoid a bank run).
- There’s a continuous fall in Greek deposits (wasn’t compensated by cash money in circulation)
2. Another problem is that the Greek government might default on its debt when it is converted from
euro to drachme (& the Greek debt in euro will suddenly explode. Holders of Greek debt (ECB/
European government + private foreign debtholders + Greek banks) will lose part of the value of
these investments.
Private foreign institutions reduced their exposure to Greece (2011) however, the reduction in exposure of
these banks has been transferred to the public sector, through ECB involvement.
Devaluation will offset these results  current account surplus and boost of the economy, but this may take
time and depends on the resilience of the Greek political system during the immediate recession after
Grexit. But it will take time.
Will the rest of Eurozone be better off?  There are 2 scenarios:
1. Pessimistic view (domino view), Grexit makes Eurozone less optimal.
The financial market will attack some other country, this contagion
effect and was the main reason that Greece stayed in the eurozone.
2. Optimistic (ballast theory), Grexit
makes Eurozone an OCA
Without Greece it will face less
asymmetric shocks because an outlier country has been eliminated.
Chapter 9: The European Central Bank
The design of the ECB: The Maastricht Treaty  Everything of the design of the ECB is in the Maastricht
Treaty (you cannot change what is in the Maastricht treaty by simple majority but my unanimity).
There are 2 models of central banking: Anglo-French versus German model. They differ with respect to their
objectives but also with respect to the level of political independence that they have.
-
-
Anglo-French model: it typically pursues several objectives, such as price stability, employment, and
price stability, and they can be given an equal weight. This model is characterized by a higher
political dependence, so there is more cooperation with the people in charge of fiscal policy.
a) The Bank of England you have a monetary policy committee and someone from the Treasure is
attending these meetings (you don’t have that in the EBC). You also must comply with rules that
have been decided by the British Parliament.
The German model: price stability is considered the primary objective; the other objectives are
secondary (if it doesn’t conflict with the price stability objective). There is less political dependence.
For the ECB it is the German model that prevails. Objectives in the Maastricht Treaty:
-
“The primary objective of the ECB is the maintenance of price stability” (article 105)
“Without prejudice to the objective of price stability, the ECB shall support the general economic
policies … with a view to contributing to the achievement of the Community …” (Article 105(1))
Institutional design: Political independence 
The Treaty is clear, it says neither the ECB nor a national central bank shall take instructions from any
governments of the Member States or from any other body. It also says “… shall be prohibited, the purchase
directly by the ECB from Community institutions or bodies, central governments, regional or local
authorities, public authorities of debt instruments.”
- Directly buying from the national governments is not allowed.
Formally the ECB has political independence, but mandates are generally decided by ministers of finance.
Goals from other central banks 
Federal Reserve: “so as to promote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates.” (=dual mandate)
BoE (Bank of England): “to achieve the Government’s target of keeping inflation at 2%. Low and stable
inflation is our main monetary policy aim. We also support the Government’s other economic aims for
growth and employment. Sometimes, in the short term, we need to balance our target of low inflation with
supporting economic growth and jobs.”
- After the Financial Crisis the BoE added a new objective of financial stability, and since then they have a
monetary policy committee but also a committee for financial stability.
Why has the German model prevailed? 
Dominating monetarism since 1970’s: monetary policies ineffective to reduce unemployment. To reduce
unemployment, labour market reforms should be used (shifting the aggregated supply curve). Monetary
policies should be used only to control inflation.
- Keynesian view (on the other hand): aggregate demand (monetary and fiscal) management can reduce
unemployment and should be used, as labour market is full of rigidities.
To enter EMU, Germany required a hard-nosed ECB.
ECB: a conservative central bank?  Is ECB more conservative (gives more weight to price stability and less
to output stabilization) than FED?
The answer is yes:
- Fed lowered short-term interest rate more quickly and aggressively to recession of 2001 than ECB.
Same for 2004-06 and 2007- 08. The Fed acts much quicker than the ECB.
a) Fed has raised interest rates, whereas in ECB it is still 0%.
- ECB reacts to output gaps, because they are a good predictor of future inflation, but less than FED
Inflation (1999-2018), was very similar in the US and Eurozone.
a) In a situation of overheating (over employment), the central bank raises the interest rates to slow
down the economy, and when the output gap is negative then the central bank will typically
decrease the interest rate (to stimulate the economy). But the ECB reacted a lot less intensely than
the Fed in response to output gaps, and that is taken as a signal that the ECB is more conservative.
ECB is only moving to preserve price stability, they don’t care output gaps but then when we look at the
figure it seems that they also move when there is an output gap.
- What happens in that period are mainly demand shocks which means aggregate demand shifts to the right
and leads to a positive output gap and at the same time it increases the risk of inflation.
- So, when you have overemployment in the economy and a risk of inflation pressure in the future, what the
ECB will do is rise interest rates, to shift the aggregated demand back.
Consensus that:
- Fed’s monetary policies during 2001–04 were too expansionary for too long  boom in US housing market
 consumption boom + housing crisis in US in 2007
- But also that the ECB’s hike in interest rate July 2008 to 4.25% was controversial. The reason the ECB did it
is because it is a conservative bank, so act in regard to inflation and it had reached 4%.
QE (quantitative easing) in US & Eurozone  started 2015 in eurozone (took long = conservative bank).
Definition = central bank massively buys governments bonds (to raise inflation), it is reflected in the balance
sheet of the central banks that starts to explode.
Reasoning = ECB started this is because of permanent low inflation in the eurozone. In 2014 for first-time
inflation became negative  One of the legacies of the financial crisis: low inflation
The Financial-economic crisis  C and I decrease (IS to left)  central banks reduce short-term nominal
interest rates to zero (LM downwards) which led to a liquidity trap.
The only way to get out of a liquidity trap is to shift the IS curve.
However still deflation pressure  Central banks use “unconventional” quantitative easing (QE) 
increases balance sheet central bank.
The Fed is quicker & more aggressive in using QE than ECB. They started in 2009 & again in 2012, 2 goals:
inflation and stimulating the economy.
During the pandemic there was another round of quantitative easing.
Independence and accountability 
The ECB has good reasons to be politically independent, to avoid monetary financing of government deficits.
But a high level of independence should go along with a high degree accountability (to avoid problems) –
control/monitoring and sanctions are necessary.
In a democracy:
- First stage: voters delegate power to politicians who exercise power independently
- Second accountability stage: electorate evaluates politicians and perhaps applies sanctions.
If politicians further delegate power to the ECB, there is correspondingly need for accountability, because
politicians maintain full accountability to voters.
Empirical evidence: ECB is more independent
but less accountable than other central banks.
Fed compares before congress that can
change Fed-statutes, by simple majority.
Whereas ECB-statutes can only be changed by
modifying the Treaty, by unanimity of EU
members. The degree of precision of ECB’s
objectives is very low:
-
Treaty is vague about definition of
price stability and other objectives
ECB has interpreted this to mean that
it has to pursue only price stability
Increasing problem of long-term political support for an institution over which politicians have no control.
ECB could enhance informal accountability
THE ECB: institutional framework 
The ECB is part of the Eurosystem. The Eurosystem consists of the ECB and 19 national central banks (of the
member states of the eurozone). We distinguish between 2 governing bodies:
1. Governing council, consists of 6 members of the executive border & 19 governors of the national
central banks. They back interest rates, reserve requirements, provision of liquidity in the system…
a) Every member has one vote (until 2015).
2. Executive board, it consists of president, vice-president and for ECB-directors. Set council’s agenda
- They implement decisions taken by the Council, including giving instructions to the NCB’s
Is the Eurosystem too decentralised?  Do we give too much weight to the national states?
Initial idea, assume every member state represents the interest of the system & not national interest.
- We have 19 governors of the NCB compared to 6 ECB board members, whereas the FOMC (Federal
Open Market Committee) has 5 presidents of regional banks compared to 7 fed-board members.
However, counterargument:
When ECB board acts in unison, its decisions usually prevail
- ECB-board uses Eurozone-system information  Germany = 30% eurozone, so German inflation
counts for 30% in the price index used by the ECB-board
Should the decision-making process in the Eurosystem be reformed?  we have 19 against 6
Eurozone Enlargement increased risk of coalitions from small countries, that counter interest of large
countries, representing 2/3 of eurozone. That is why the voting procedure has been modified since 2015:
-
6 votes for the Board
Maximum 15 voting governor in Council, with a rotating basis much that governors from large
countries vote more frequently than governors from small countries.
Large council size to take quickly major decisions, about OMT programme, QE…
The ECB as lender of last resort  In severe liquidity crisis, ECB acts as lender of last resorts to private banks
This happened for the first time in 2008 with the financial banking crisis. In October 2009 with the Lehman’s
brothers bankruptcy. The subprime (mortgage, loans) crisis spreads to the EU, frozen interbank market, and
deposit holders withdraw their money. There is a liquidity crisis in the interbank market and the ECB reacts
quickly with liquidity injections.
ECB was reluctant to be lender of last resort in government bond
market. In September 2012 when Eurozone was close to collapsing.
The ECB announced it would buy unlimited amounts of governments
bonds (Outright monetary transactions OMT)  spreads
immediately declined.
Shareholders equity on liabilities (also)
The OMT program was limited to bond with maturity < 3 years and
conditional on austerity program to control moral hazard risk. If you
take a bond with above 3 years, they feel safe and might let the next
government worry about it.
Monitoring political moral hazard risk is important; however, deciding about G and T is not the task of
“politically independent” ECB, but of the (admittedly ineffective) SGP
- Bagehot doctrine: the lender-of-last resort should be used to provide liquidity to solvent institutions + in
times of crisis, to deal with moral hazard, central bank can provide unlimited liquidity at a penalty rate.
Did the ECB violate its statutes when it announced its OMT? 
German Constitutional Court: yes. They said the ECB is not allowed to buy an unlimited amount of
government bond of a particular country, that would violate the statutes of the ECB.
But then the European Court of Justice (ECJ) in 2005, said no because the OMT programme is okay, and their
argument is you are sampling buying government bonds on the secondary market, so what is the problem?
The distinction between open market operations and monetary financing is often confused:
- Article 21: “ECB is not allowed, nor can ECB purchase directly debt instruments from these public entities. “
- ECB is allowed to buy government bonds in the secondary markets in the context of its open market
operations, to provide liquidity to the holders of government bonds, typically financial institutions.
Problem: Legally: clear distinction primary & secondary markets. In practice the distinction can be blurred.
Example: An Italian bank subscribes to newly issued Italian government bonds (primary market) next day it is
selling these bonds to the ECB (secondary market). If the Italian bank has been pushed by the Italian
Treasury to subscribe to newly issued government bonds, we come very close to a monetary financing of
Italian government budget deficit by the ECB.
ECJ advised the ECB to allow for a reasonable time between operations in the primary market and its buying
activities in the secondary market, without specifying what ‘reasonable’ means.
The new financial regulatory and supervisory structure in the EU: towards a banking union 
2008 banking crisis triggered fundamental reform of banks/financial market regulations & supervision
-
Problems once financial integration took off: regulatory patchwork (cross-border banks were
imposed different prudential requirements) + no level playing field
National regulation and supervision that existed before the crisis (=minimum harmonization) was
seen as having contributed to the crisis => need for maximum harmonization for EU (not only
Eurozone).
De Larosière Report (2009)  A Common regulatory framework: since 2011 (for whole EU)
The European Commission mandated Larosiere to access the problems with the current regulatory and
supervision framework. They delivered a report with an assessment of what caused the financial banking
crisis and with solutions/proposals to avoid it happening again.
The advice of the report was immediately taken into account. One of the things that was proposes was a
European systematic risk board (headed by the ECB president). It had the mission to issue early warnings and
analyse systemic risks on the basis of micro prudential info.
Another proposal was to create 3 independent European supervisory authorities: EBA, EIOPA, ESMA. Their
mission is to foster maximum (instead of minimum) harmonisation and creation of common rules:
-
Legislation in the ‘Single Rulebook’
Technical standards, guidelines and
recommendations, and other ‘soft law’
instruments, such as the Q&A tool (=answers
provided by EBA regarding interpretation of
common rules)
Can overrule national supervisors if they fail to comply
Towards a banking union 
The vicious circle of the doom loop: Problems in the
banking sector (f.e. firesale of subprime mortgages in
crisis 2007) had a negative impact on the sovereign
debt, as national governments had to bail out commercial banks with public tax-money. Budget problems
(intensified by increasing risk premiums on government bonds) resulted in negative effects on banks’
balance sheets because of the decline in the value of government bonds in the banks’ asset portfolio
Negative spiral when banks hold sovereign debt on their balance sheet and governments bail out banks
which further increases government debt)  banking union to break the doom loop?
Banking union breaks this doom loop: avoids bail-outs (from now on bail-in via SRM), avoids bank runs (via
common deposit insurance mechanism), guarantees level playing field banks/avoids pressure on national
banks (via SSM)
3 components:
Single supervisory mechanism 
It has the task to supervise the balance sheet of systemic banks. The definition of a systemic bank are bans
with a balance sheet exceeding 30 billion € or 20% of the national GDP. If they run into problems, you must
help them because if not there will be spill over effects into the whole economy.
There is an agreement since 2014 that the supervision of these systemic banks will be done by a centralized
level by a supervisory board (within the ECB), that consists of representatives of +4 ECB representatives and
representative of the national authorities (chair + 19). Some of the tasks:
-
Auditing of balance sheet
Imposition of fines
Recapitalization of banks
Their closing down when necessary
Aside from that you still have 6000 smaller banks that are supervised by national supervisors. However, ECB
Board of Supervisors is empowered to overrule them if they fail to act.
Single Resolution Mechanism  operation since 2016
A Single Resolution Board (chair +4 ECB representatives +19 National Authorities Representatives): decides
about resolution of systemic banks, to avoid bailouts paid by State aid and taxpayers.
The aim is that if systemic banks risk to become insolvent and must be resolved then, this resolution should
be efficient (meaning without impact on the taxpayer or budgetary authorities having to help these banks).
- Ex: resolution Banco Popular (bankrupt due to toxic real estate assets on balance sheet) and there was a
takeover by Banco Santander. Shareholders of Popular capital lost everything, taxpayer didn’t pay anything.
Any resolution is first financed by shareholders, creditors, “savers” principle of bail in (the shareholders must
share in the losses). This gives the shareholders the incentive to behave well – so it solves the moral hazard
issue. If it is insufficient, a common resolution fund is set up €25billion in 2019 and € 55 billion by 2024.
- National supervisors continue to decide about resolution 6000 smaller banks.
Single deposition insurance system  under discussion, there is no political agreement.
Today every country has its own national deposit insurance mechanism  banking crisis  losses of the
depositors compensated by national governments.
The European Commission proposed in 2015 to set up a European Deposit Insurance Scheme (EDIS). The
reason we don’t see a political agreement on this system is because there is a higher risk of a bank run – if
6000 banks are under national supervision, it is hard to see an agreement like this happening. Because this
6000 bank might start to behave differently if they believe they are safe (so there is a moral hazard risk).
A common Eurozone deposit insurance mechanism spreads the cost of compensating the deposit holders in
one country over the Eurozone as in the US. This necessitates willingness of member-countries to transfer
resources to a member-country hit by banking crisis. But if deposit holders remain confident/do not
withdraw, no single euro would leave the SRF….
Banking union attracts also non-eurozone EU members 
All EU members follow Single Rule Book of ESAs. They can voluntarily opt to join (or leave) the SSM and SRM
“close cooperation agreement” with ECV, thereby obtaining a seat in the Board of Supervisors.
- Sweden and Denmark are interested in such a banking scheme, and of joining.
- The banking union is likely to improve financial integration in the EH (and to trigger harmonisation of
corporate and accounting rules for banks and firms).
Chapter 10: Monetary Policy in the Eurozone
There will always be someone unhappy.
The Taylor Rule  another way at looking at symmetry (extent of asymmetry between members states of
the Eurozone) is calculating the optimal interest rate for every member states of the Eurozone given the
output gap in that specific country and given the deviation from the observed inflation to a target inflation.
- If optimal interest rate is very different among members that is a signal that there are large asymmetries.
Equation describes very well the interest rate police of the Federal Reserve in function of deviation inflation
with respect to target inflation, and in function of the output gap (observed output and the natural output).
ECB decides desired interest rate, often close to the desired interest rate of large countries like
Germany/France. But, due to asymmetries, deviates from desired interest rates in periphery countries.
- It is very difficult for the ECB to decide on an interest rate that is good for all the member states.
ECB sets a single nominal interest rate for eurozone However, inflation differences within Eurozone,
combined with single nominal interest rate, create differences in real interest rates, affect housing prices.
- Low real interest rates stimulate demand for houses  increase house prices  housing bubble
Ireland/Spain
- To avoid housing bubbles: macro-prudential stabilizers f.e. loan-value ratio in function of economic growth.
The Monetary Policy Strategy of the ECB  The strategy has been fully revised, which was a result of the
weakness of the previous strategy.
It gives the ECB a framework that allows them to take decisions on its monetary police. And it consists of
price stability as the ultimate target and the two-pillar approach.
Definition of ultimate target (=price stability) “a year-on-year increase in the Harmonized Index of Consumer
Prices (HICP) for the euro area of below but close to 2%” & “to be maintained over medium run”
- ECB President Duisberg (1998): “below 2% clearly delineates the maximum rate of inflation deemed to be
consistent with price stability”.
- New strategy target is 2% (not bellow) – anything that is bellow or above is equally risky and important.
Initial 2 pillar approach:
1) Monetary Analysis (quantity theory)
2) Economic Analysis: economic analysis to monitor variables that allow to forecast inflation: wages,
exchange rate, price and cost indices (energy prices), bond prices…
The Monetary Police Strategy of the ECB: an evaluation 
Did the ECB reach the target of the 2%? From 1999 to 2007 it was around 1.7%. The inflation since 2008
(after the crisis) you see that on average it is lower than 2% and that was a big concern for the ECB. In
January 2015 the ECB interest rates for the first time reached the 0 lower bound, they reduced the interest
rate to 0% from 2015 onwards. And that is the moment they started with quantitative easing.
In August 2020 we have negative inflation, this is probably due to Covid 19. And in 2021 there is an inflation
of 4.1% in the euro area (rising energy prices in heating and transport fuel).
The target is inflation stability, but exclusive targeting of inflation does not necessarily mean that other
objectives cannot be realised at the same time. This is where you should make a distinction between
demand shocks and supply shocks.
If the aim of the ECB is price stability, what should it do? Restrictive monetary policy to shift the aggregated
demand back to position and then prices remain stable, and this means raising the interest rates.
The problem is rather when we have a supply shock,
aggregate supply shifts left. You price inflation &
unemployment. What can the ECB do keep prices
stable? Deepen the recession & shift the aggregate
demand to the left to keep prices stable – but this
would deepen the recession in the short run.
AD shocks: Inflation targeting is consistent with output
stabilization  no trade-off for ECB
AS shocks trade-off for ECB between output and inflation stabilization
ECB will choose inflation stabilization. Output stabilization can again be conciliated with inflation targeting
approach: a gradual transition to the inflation target “over the medium run”.
Although output gap positive since 2-17, inflation is still below 2%; ECB continued QE to raise inflation.
Financial Stability: an additional objective? 
Before the financial crisis of 2007-2008: the beginning thought was that when you target price stability it
minimizes risk of financial instability. And that the responsibility for financial stability is in the hands of
national supervisors/regulators.
However, after the crisis, reform with single rulebook + SSM / SRM. If there is no trade-off, price stabilization
 financial stability. But if there is a trade-off, ECB has to make a choice  Is there a trade-off?
Is there a trade-off between price stability and financial stability? 
Suppose a technological IT-shock Increase stock prices, decrease cost capital, increased investment in new
technology increase productivityAS shifts downwards
- Consumer spending increasesAD shifts to the right
- Suppose P decreases
- If ECB targets P* monetary stimulus beyond natural output asset bubble
Quid impact Covid 19 on AD-AS? 
There were forced savings (because everything was closed), so the aggregated demand curve really shifted
to the left (because of decreased consumption). There was an increased speed of adoption technologies +
new digital technologies + increased awareness about the importance of technological innovation  AS
- There was negative inflation during Covid. There were very low interest rates  asset prices on stock
markets and housing markets up.
- Quick recovery in 2021 AD and supply chain distortion AS
- Inflation 4% in 2021: temporary or permanent?
- Which monetary policy?
How to define and monitor financial stability? 
Borio and Lowe (2002), Kindleberger (2005) define financial instability as twin phenomenon:
-
Excessive growth in bank credit
Large increases in asset prices
 monitor financial stability by focusing on a limited number of indicators
Before crisis 2007-2008, DGSE models: assumption of perfectly informed and rational individuals => financial
crises cannot occur. After the crisis, DGSE models also model financial crises.
ECB new strategy takes into account financial stability in all the analyses.
Excessive reliance on the money stock?  How successful was the monetarist strategy, based upon
quantity theory of money? According to Milton Freedman, inflation is a monetary phenomenon and that
when you see it, it means that the money supply increases faster that the real GDP. & in long run, he’s right.
But since 1999, M3 growth had no power to predict inflation in Eurozone.
-
Prior 2008: M3-growth > 4.5%
End 2008, M3-growth dropped to 0% and inflation to 0%
2010–14: correlation M3 and inflation
From 2014-2019: M3-growth > inflation
Quid M*V = P*Q (=equation of Fisher, = identity)? the assumption of a constant velocity of money, in
quantity theory of money, is not realistic. The velocity of money is declining and that is why increasing the
money supply by 5% doesn’t lead to inflation of 5%.
Rapid expansion of M3 2004-2008 did not signal future inflation in the consumption goods/services, but
instead inflation in asset markets/future financial instability = counterpart of massive expansion of balance
sheets of banks that were allowed to increase their risky credit portfolios.
Inflation targeting: a model for the ECB? 
-
-
Inflation targeting: Inflation targeting (used in Bank of England, Canada, Norway, Sweden): superior
to money stock targeting because central bank uses information of all variables (including M3) that
affect future inflation, while money stock targeting omits much information.
a) They strive for inflation expectations of 2%
b) And as they take into account all information, that is why this is superior.
Since 2003, two-pillar approach ECB sets “reference value” for M3 (not a target)+ECB also uses
information on all variables
Whatever, it must be complemented with monitoring financial stability to prevent bubbles asset
markets from destabilizing banking system.
Revision of ECB monetary strategy  July 2021
a) Trend decline natural interest rate (ageing + slowdown productivity)  from asymmetric (“lower
than but close to 2”)  Symmetric target: 2%. It means that everything that is above or below 2% is
equally important and risky.
- Implication: interest rate policy (zero lower bound) will be complemented with monetary policy of
large asset purchasing, although “with a view to minimising side effects”
b) Medium run: to handle trade-offs price-output in smooth way
c) HICP will be complemented with index on housing service costs for houseowners (owning +
maintaining). By 2026 integrated price index
d) From dual-pillar strategy (monetary + economic)  integrated analytical framework with economic
+monetary + financial analysis  Financial stability is taken into account
e) New assessment in 2025
The Instruments of monetary police in the Eurozone 
- Open market operations: among them you have the main refinancing operations through tender
system (and providing liquidity to the market) and QE (direct buying in secondary markets).
- Standing facilities: credit lines
- Minimum reserve
Main refinancing operations, how do these work? Procedure:
First: Governing Council sets the interest rate applied in the main refinancing operations (REPO rate).
Second: ECB announced a tender procedure, and all financial banks and institutions can participate and
request liquidity (they can bid for the liquidity that they want). There are 2 types of tender procedures:
1) Fixed rate: banks only bid for the amount, it means the interest rate was already fixed by the
governing council, and then the financial institutions can bid for liquidity that they want.
2) Variable rates: banks and financial institutions can bid for the amount of liquidity that they want and
at the same time they can indicate how much they are willing to pay for that.
- Banks bid for amounts of liquidity at successive interest rates with REPO as the minimum
Third: bids are collected by the NCBs and centralized by the ECB. ECB decides about the total amount to be
allotted, and distributes this to the bidding parties pro rata the size of the bids.
Impact of money market: By increasing or reducing the interest rate on its MRO it affects the market interest
rates by changing the size of the allotments it affects the amount of liquidity directly.
Since financial crisis:
Until 2008 (the collapse of Lehman brothers) they used the variable interest rate. Since 15th October 2008,
only fixed rate tenders “with full allotment”: banks obtain all the desired liquidity at the predetermined rate
/ ECB’s = lender of last resort
- The interest rates declined and decline until 2015 onwards they are set at 0.
Since June 2009, Introduction of LTRO (long term refinancing operations). It means that banks can use as a
collateral assets with the maturity up to 3 years.
- The Euro system provides these commercial banks liquidity against a collateral (for 1 week), and when the
term of the loan is over the collateral will be given back. Eurosystem provides liquidity to banks against a
collateral provided by the banks
Eurosystem accepts a broad range of assets as collateral. Although they have to be of a certain quality to be
eligible as collateral. Two sets of eligibility criteria:
-
Marketable assets: credit ratings will be used
Non-marketable assets: Eurosystem applies its own risk assessment.
Since October 2008: ECB relaxed eligibility requirement of collateral presented by banks from A to BBB
- When ratings of Greek government bonds were downgraded in 2010, ECB exempts these from rating
requirements
- The quality of the collateral is important, otherwise it doesn’t make any sense.
- Eberl-Webber created an index that stands for the quantitative and qualitative characteristic of the
collateral pool, and since 2008 the type of collateral is broadened and the quality required has reduced.
Date and policy measures undertaken by ECB:
QE: How does it work? 
It simply means that the Central Bank is directly buying government bonds on the secondary market (of
course of the secondary market if not we would call it monetary financing of government debt). They buy a
lot of government bonds and they have been doing so since January 2015.
The trigger for the ECB was to counter the risk of deflation. Since 2011 inflation is going down, and it risked
becoming 0 or negative in December 2014 – there was a risk of deflation, especially as inflation expectations
were going down as well.
Open market purchases government bonds are non-conventional instrument due to size of the purchase.
-
Since January 2015: every month €60 billion of government bonds
In October 2017, reduced from €60 to €30 billion
-
By the end of 2018 no further net purchases/reinvestment maturing bonds
September 2019: restart of QE € 20 billion per month
Does it lead to moral hazard? Some Northern countries feared this, because it would further reduce fiscal
disciple and could lead to fiscal transfers. So, the solution:
-
Each NCB buys bonds of its own country. How much? According to equity shares (so the importance
of the country in the eurozone).
Keeps 80% of these purchases had to be kept on the domestic balance sheet of the domestic central
bank; the remaining 20% on balance sheet of ECB could lead to fiscal transfers (that way in case of a
Grexit you only have a loss of 20%).
The Federal Reserve started to downsize their balance sheet, they started to quite QE by the end of 2018,
and they started to raise the interest rates. However, the ECB decided to continue with quantitative easing
and that led to disagreements in the governing council. 9 out of 25 members of the council were against the
QE package – the critique was to keep it for when we really have problems.
Impact of QE in Eurozone: NCBs of Spain/Italy received high seniority gains, while NCB Germany recorded a
loss due to negative interest rates on German long-term bonds.
Standing facilities  aim to provide and absorb overnight liquidity. Banks can use marginal lending facility to
obtain overnight liquidity:
-
Marginal lending rate =typically 1% above repo; = ceiling for the overnight market interest rate
No borrowing limit, provided collateral.
Banks can use deposit facility to make overnight deposits: interest rate on the deposit facility
=typically 1% below repo;
=floor for the overnight market interest rate;
Since June 2014, negative because repo dropped to 0.05%
Minimum reserves 
Through reserve requirements the ECB can affect liquidity & money stock in money market Promoted by
Bundesbank, but resistance from commercial banks who argue a competitive disadvantage w.r.t. UK banks
ECB does not use the minimum reserve requirements as an instrument of monetary policy. Though, easy
way to limit excessive credit availability of commercial banks  if the aim is not only price stability but also
financial stability,
- Other possible instrument: macro-prudential control. F.e. loan-value ratio applied in mortgage lending, but
competence of NCB’s.
The Eurosystem as lender of last resort during the financial crisis 
ECB has been active lender of last resort in the banking sector since October 2008: during 2011-12 the ECB
provided >€1 trillion of liquidity to the banking sector. ECB bought for about €165 billion of government
bonds in the context of its “Securities Market Programme” (SMP).
SMP (May 2010) should not be confused with OMT(September 2012):
-
OMT programme: ECB commits itself to buying an unlimited amount of gov bonds unlimited in time.
SMP programme (in times of pressure on Southern Eurozone countries): ECB announced that it
would buy a limited amount of bonds during a limited period of time.
SMP gave a signal to holders of government bonds to sell as quickly as possible; As a result, ECB had to buy a
lot of these bonds < > ECB did not buy a single government bond in the context of OMT because the
confidence the bondholders had was sufficient to keep these bonds.
As a consequence of these liquidity injections the balance sheet of the Eurosystem expanded massively. But
expansion of balance sheet of Fed and Bank of England was even stronger.
Chapter 11: Fiscal Policies in Monetary Unions
Suppose an asymmetric shock, a decrease in AD in France and an increase in AD in Germany. 2 cases:
1) France and Germany form MU and budgetary union. What would happen?
Centralized budget works as insurance mechanism: French spending on unemployment benefits increases
and German tax revenues increase  transfers from Germany to France
- Ex-ante risk sharing  Ex-post redistribution
Centralized budget reduces fragility of government bond markets: France obtains funding, without need to
issue bonds. If French deficit > German surplus, issuance common euro-bonds
2) France and Germany form MU without budgetary union (which is the current situation)
French deficit + issues bonds to borrow < > German surplus + uses this to invest or save.
- France increases its debt: future French generation pay for unemployment benefits of French people today
- If we had a fully integrated capital market: Germany buys French bonds; if not, fragile government bonds
markets: lack of confidence among investors => high risk premium => further increase French debt.
In both situations the insurance system should only be used to deal with temporary/business cycle shocks so
as to give temporary transfers. If shocks are permanent, fundamental adjustments are necessary: wage and
price flexibility and/or labour mobility.
If not 
In 1): Permanent transfers  Box 11.1.
In 2): risk unsustainable government debt
Box 11.1 How much centralization of government budgets in a MU is desirable?  Centralized budgets
have a moral hazard risk.
Evidence within countries, we see that supposedly temporary transfers become permanent:
- Mezzogiorno in Italy
- Wallonia in Belgium
- Eastern Lander in Germany
Difficult to keep it temporary & this is because with these transfers there is a moral hazard risk. It keeps real
wages in the regions that are negatively affected too high and there is no incentive for labour mobility or to
adjust the labour mobility. So, when these transfers seem to have a permanent character then the idea of
creating a budgetary union will face huge political problems (and that is what you see in the Eurozone).
Extension OCA-theory by Kenen (1969)  Desirable to centralize part of national budgets at European level:
- Risk sharing
- Reduction fragility government bond markets
If this is not possible to have such a budgetary union (as is the case for EMU as temporary transfers turn into
permanent) then, “national budgetary authorities should enjoy autonomy to use automatic budgetary
stabilizers in a flexible way”. However, it is heavily criticized because the possible spill over effects to other
members must be managed.
Sustainability of government budget deficits 
The assumption “adverse shock absorption through deficits has no impact of budgetary (un)sustainability”
is not confirmed by the evidence.
When do budgetary deficits lead to unsustainable debt dynamics?
Snowball effect: you are unable to limit the increase on debt ratio, that means that the debt ratio will
increase in an uncontrollable way - this will happen when the initial debt ratio is high.
Solvency conditions for sustainable debt dynamics:
-
A necessary condition that stabilizes b is to run primary surpluses: ( r  x )b  (t  g )
A necessary condition for solvency may be not sufficient, if the level of b is too high => the primary
surplus should be sufficiently high!
Let’s look at the evidence:
1) Belgium, Netherlands & Italy, 1980 - 2007
2) r-x before and after the crisis of 2008
Government Budget Deficit in Belgium, the Netherlands and Italy 
In Belgium from the Maastricht treaty, government budget deficits seem to decline. But it took 10 years to
reach a budgetary surplus, this is because the interest payments that the Belgium government had to make
(and still has to) were so high.
The evidence in west-European countries is that large budget deficits lead to unsustainable debt dynamics At
end 90’s in Belgium and Italy: decrease nominal interest rate, economic growth, increase T, decrease G =>
primary surpluses to reduce b but still b > 60%.
 budgetary norms in Maastricht Treaty (to enter the eurozone) and SGP (also after the start of the
eurozone)
Before the crisis:
-
Ireland, Spain, and Greece: r – x < 0, while Italy and Germany had r – x > 0.
Thus, Ireland, Spain, & Greece could stabilize or reduce b (to 60%) without having to create a
primary surplus;
-
Italy & Germany could stabilize b only by producing a primary surplus.
After the crisis:
- Spain, Greece: r - x > 0 while Germany r - x <0
- Ireland, Germany, Austria, Belgium, & Finland can stabilize b without producing a primary surplus
Stability Growth Pact in 1997  Common MTO for all member states: Balanced budget over medium run
(i.e. over the business-cycle). It consists of surveillance and sanctions.
Surveillance part: early warning
1) EMU-members lay down stability programmes about how they aim to reach a balanced budget over
medium run
2) Council formulates an opinion (based on EC-recommendation)
3) During programme, Council formulates a recommendation on adjustment measures.
Dissuasive part with fines:
- Germany wants automatic fines to ensure enforcement < > other countries.
- If excessive deficit (> 3%GDP, except if exceptional circumstances:
1) unusual event outside control like natural disaster
2) annual decline GDP >=2%)
- Council decides whether it is excessive deficit
- Qualified majority of Council might decide to impose a sanction
These sanctions were never applied.
SGP was revised in 2005 (to weaken rules). The first countries that breached the SGP were France and
Germany, they had a deficit higher than 3% on GDP and they had a declining GDP (but not more than 2%),
and they didn’t want to pay a sanction. Under the pressure of Germany and France in 2005 they decided to
change the pact to weaken it such that they couldn’t impose fines in the future.
Revisions:
- Excessive deficit ( = deficit> 3%GDP, except if:
1) unusual event outside control like natural disaster,
2) annual decline GDP (any decline:OK)
3) deficit due to structural reforms or public investment
- No fines will be imposed
- Country-specific MTO (mid-term objectives) based upon the country’s current debt-to-gdp ratio and
potential output growth. They decided to differentiate the requirements depending if the country a
very high GDP debt ratio in the beginning.
- Structural balance (=cyclically-adjusted balance, netting off business-cycle impact & one-off
measures) must still be 0
- SGP revision in 2011 (political compensation for the Netherlands & Germany for the bailout of
Greece) MTO into national legislation:
- 0.5% structural deficit if debt-to-GDP > 60%
- 1% structural deficit if debt-to-GDP < 60%
- If debt-to-GDP>60%, it should reduce by 1/20 on average over 3 years
Strengthening preventive part:
National governments present national budgets to the EC before these are presented in national
parliaments: European Semester EC has more power to obtain information from national governments.
- A fine of 0.2% on countries that falsify statistics
- Possibility to relax structural deficit requirement in exchange for structural reforms
The argument for rules on government budget deficits in MU 
-
-
When a MU-member is allowed to accumulate unsustainable debt, it can create negative spillover
effects for the rest of MU (ex: Greece in 2010).
It raises the overall level of the interest rate in the monetary union, (what happened in Greece also
influenced the interest rates in Spain), and the dynamics may drive up the level of interest rate in
the Eurozone and put a debt burden of other MU-members and may lead them into recession. It is
the interest of the members of the eurozone to prevent this. In extreme case, ECB may be forced to
prevent sovereign debt default, by buying bonds of specific governments.
Raises overall inflation + exchange rate euro, decreases competitiveness of other MU-members
Can we rely on private capital market to induce fiscal discipline?  No, it is not efficient. Imposing rules on
deficit is necessary.
-
Efficient capital markets  financial investors price government bonds differently  no spillover
Financial markets are not efficient:
1991-1998: spreads decline because devaluation risk wrt German mark declines
1999-2008: financial market priced the spread =0
2008: financial markets suddenly start to price the risks of default of government bonds
Since September 2012 (OMT): although still diverse deficits/debt unsustainability, spread lowered
What is the sense of fiscal rules that are not enforceable? 
Fiscal rules are only effective if they are enforceable, and this is a big problem that still hasn’t been solved in
the Eurozone. We have a framework, but a lot of countries breach the rules without consequences.
Example: Gramm-rudman legislation US 1986- 2002: mechanism that triggers automatic spending cuts
when deficits get too large
- Political advantage: takes away pressure from politicians in office who “are not to blame” for the cuts
- Focus on spending rather than on the deficit: good thing from point of view of macroeconomic policy
However, enforceability problem: spending “off the budget”, even with constitutional rules.
Eurozone: same problem of enforceability, leading to:
- “off-budgeting” or misreporting of numbers/falsifying of budget statistics
- Creative accounting: selling government assets (building, railway carriages,…) & leasing them back
Ex: sale assets (5billions euro) of state-owned pension fund in Belgium in 2003-2004
Thanks to revision SGP in 2011, EC has more power to obtain information of national governments, but
even though they tried to tighten the pact they didn’t produce the hoped effect.
Does the fact of belonging to a MU increase or reduce fiscal discipline of the MU-members? 
If a country issues debt, interest rate reflects a risk premium (=risk of default + risk of devaluation).
Being in a monetary union leads to less fiscal discipline because the risk that a country faces when it uses
debt is different depending on whether the country is a monetary union or not. And it depends on how the
private markets can bring discipline.
Without a MU: instead of the risk of default you have the risk of depreciation. Too much debt can lead to a
risk of devaluation (interest parity condition), then external debt increases and there is less incentives to
issue excessive debt.
In a MU: instead of the risk of devaluation, you have the risk of default. If the is “no bailout clause” is not
credible and if private capital markets fail to see price default risk, then the moral hazard argument will
dominate (incentives to issue debt)  less discipline.
In a MU you can argue the no monetization argument. This refers to the inability to issue debt in domestic
currency may be perceived by MU-members as a harder budget constraint=> more discipline. Which
argument prevails, depends on strength institutions:
For the eurozone:
- Moral hazard explains debt sustainability problems
- Independence ECB keeps average eurozones debt “relatively under control”
For US: soft budget constraint (possibility for monetization) (also because dollar=reserve currency)
Riks of default and bailout in a MU 
McKinnon (1996): high government debt of some eurozone-members  probability that some MUmembers will stop paying interest on outstanding debt increases = risk of default increases in MU.
- This is exactly what happened afterwards.
The Stability and Growth Pact: an evaluation  There are 2 conflicting concerns.
-
There is the need for automatic stabilizers in case of recession
There is a need to avoid unsustainable debt dynamics with spillover effects to other member states
We still have no adequate framework for fiscal discipline. Over time, revision of SGP shows increased
awareness to reconcile these two concerns. But there are still flaws:
1) Arbitrary budgetary norms 60% debt-GDP and 3% deficit:
If growth =5% (Maastricht treaty)  3% deficit stabilizes debt at 60%GDP
If growth =3% (average 1998-2017)  1.7% deficit stabilizes debt at 60%GDP
Fiscal compact requires structural deficit <1% (if b < 60%) and 0.5% (if b > 60%); but 0.5% structural deficit
compatible with stabilizing b at 0%.
It is an inconsistent framework; at the time the Treaty of Maastricht was signed the average growth rate of
GDP was 5% and policies makers used that was an assumption (that growth rates of GDP would remain the
same). But under this assumption the 3% deficit would be consistent with a debt to GDP of 60%. But the
growth rate 98-2017 the growth rate was only 3%, so it should be a 1.7% deficit to stabilize GDP at 60%.
2) Difficult to conciliate with public investment
Public investment is important: 1) private sector is risk averse; public authorities can bring back short-term
confidence; 2) long term GDP-growth requires public investment
However Fiscal Pact implies public investment cannot be financed by bond issue, but by tax revenues. Not
intelligent because:
-
The economic reason, we have today 0% interest rates. So there is bond issuance at 0% while the
rate of return (ROI) is higher than 0%.
Political bias against public investment, they have few incentives to promote public investment
because the cost of that will be current tax payers while the benefits will be for the next generation.
Expenditure rule help (proposal Fiscal Board (2020) discipline for recurrent primary spending not investment
- An expenditure rule that only applies to recurrent spending, to primary spending, social spending would
not penalize public investment. Drop the deficit rule and if we were to move towards an expenditure rule
that only punishes excessive spending, then public investment would escape from that framework.
3) Not enforceable
2003-2004: France & Germany had a deficit higher than 3% & refused to pay sanctions that they should
have paid according to the excessive deficit procedure. Political decision by Council: no sanction for France
or Germany, and this lead to SGP becoming dead letter.
- This is a political problem, so some people suggest that the decision to implement the sanction should not
be taken by the Council of the minister of Finance but by Independent Fiscal Council.
Since end 2021, talks are ongoing among European policymakers on reforming the SGP.
A join issue of common bonds  common Eurobonds (it has always been a controversial topic)
Eurobonds mean that eurozone member states issue debt jointly. It is a decision of the European
Government, and it binds all eurozone member states to pay back the interest rates of these bonds when
they come to maturity. The main advantage is that the participating countries become jointly liable, and it
reduces the liquidity risk for member countries. It reduces the default risk.
There is strong resistance in a many countries because:
-
Incentive for countries (pressure from these countries) to issue too much debt = moral hazard risk.
There are no incentives for low-risk countries (Germany, Finland, Netherlands) who profit from triple
A ratings, to participate.
Triple A ratings can easily get additional funds from the capital market, so they have no incentive to
participate in the joint issue of Eurobonds.
Feasible proposal is a combination of:
a) Participation in eurobond limited to 60% of their GDP (blue bond with good rating); the rest is red
bond (with higher risk premium and lower rating) (Bruegel)
- Decline in average debt cost makes it easier to service the debt and increase in the marginal cost of
the debt provides strong incentives to reduce the debt level
b) Differential interest rates (De Grauwe and Moesen): countries pay an interest rate in function of
their fiscal position.
- Countries with high debt levels pay a high interest rate, countries with low debt levels pay a low
interest rate
c) 2021-2026: EC issues every year 150billions euro bonds on primary market (NGEU) to invest
together in common priorities (green+digital), good ratings (AAA/AA)=signal of commitment to stick
together