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EC315 - Lecture 10

Economic and Monetary Union (EMU) – union in which national currencies are replaced by a single EU currency managed by a sole central
bank (ECB in Frankfurt; 16 national CBs) that operates on behalf of all EU members
Maastricht Treaty (1991) – set out a set of macroeconomic convergence criteria that EU countries would need to satisfy admission.
a. Price stability (no higher than 1.5% of average 3 lowest inflation EU members)
b. Exchange rate stability
c. Budget discipline (max public deficit 3% of GDP; maximum public debt 60% of GDP).
ECB role (political appointments): MP analysis of monetary trends (money growth target) and analysis of dynamics and shocks
(inflation target)
Revised ERM – check notes.
SHIFT IN DEMAND AWAY FROM B TO A (initially in full employment and BOP equilibrium).
Example 1: no currency union.
Natural terms of trade depreciation (limited if monetary authority cares about inflation).
Internal devaluation through falling prices and wages (limited if B doesn’t allow prices to fall).
Depreciation (not if fixed exchange rate system).
Thus, surplus countries restraining prices have recessive impact on the world in a fixed exchange rate regime.
Example 2: currency union, closed-economy.
Now suppose A and B are within a closed-economy and have a common currency (think Euro area).
CB may expand money to correct unemployment in B ⇒ inflationary bias - depends on surplus countries’ willingness to inflate.
Labor mobility (B moves to A to correct unemployment in B.
Fiscal Transfers.
Optimum Currency Area (OCA) – region where best to have a single currency (depends on economic integration – trade, factor mobility,
common fiscal policies (transfers), similar business cycles.
Conditions: high labour mobility (no need for large fall in wages), fiscal integration, (maybe) banking union, ECB as lender of last resort.
Reduces transaction costs.
Elimination of currency risk.
Loss of policy flexibility – internal devaluation is slower.
One-size-fits-all MP.
The US – currency and fiscal union; share federal revenue and transfers. EU doesn’t satisfy these conditions as effectively.
Fiscal discipline is important as excessive borrowing by one country exerts externalities on others:
Savings and interest rates - high deficit countries absorb a large fraction of area’s saving which increases interest rates.
Monetary Policy - more difficult to raise interest rates; could bring a highly indebted government to the verge of default.
Contagion risk - if one country defaults, makes banking system of other countries fragile.
Stability and Growth Pact (SGP)
Close to balance or in surplus of government budget.
3% of GDP limit on government deficits.
Financial penalties on countries that fail to promptly correct excessive deficits and debt.
Automatic stabilizers – FP policy is often countercyclical, but the SGP forces fiscal policy to be procyclical.
Excessive focus on budget deficits – focus should be more on long term sustainability and debt rather than deficits – Structural versus
cyclical deficit
Why zero deficit over the cycle? – Forces 0% debt/GDP in the long run. Inefficient. – Poor accounting for public investment.
One size fits all – SGP does not take into account each country initial debt or long term prospect.
Lack of enforcement: – Excessive deficit procedure launched against Germany and Portugal but suspended before fines were ever
Euro Crisis - large capital flows from Germany to periphery, which caused higher inflation and wages in periphery. There is a sudden stop in
capital flows, periphery countries with out-of-line unit labour costs and prices – causes internal devaluation.
Lack of fiscal integration (government solvency).
Absence of federal bank backing (individual governments bore the burden of bank bailouts).
Sovereign defaults can lead to banking crises (banks hold sovereign debt which drives down price of sovereign debt).
There is no lender of last resort (Spain/UK example – check notes)
Case Study – Portugal (check notes for detail)
Dramatic reduction in country risk – nominal interest rate fell from 16% to 4%; expectation of convergence – euro borrowing; fiscal
policy was not leaning against the wind; unemployment declines, output increases despite poor productivity growth (PG); rapid
increase in nominal wages – loss of competitiveness so higher CA deficit.
2.3% GDP growth since 2002; unemployment back at 7.8%; low productivity growth of 0.7%; low demand (rise in private saving);
nominal wage growth is stagnated (higher than PG) and overvaluation continues 10% leading to very large CA deficit.
Slow and painful adjustment – need to eliminate real appreciation; requires smaller wage and price increases than compared to EU
area; without PG achieved by a long and painful recession.
Potential for explosive situation – self-fulfilling prophecies through expectations; default risk; exit from EMU.
High integration of Bank Guarantees; system of “Lender of Last Resort”; high labour mobility (Mundell) and fiscal integration (Kenen