BW chp 11 slides

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Chapter 11
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Chapter 11
Optimum
Currency Areas
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The question of a single currency in a large
area
• Should currency area borders coincide with national borders?
– is it a good idea for California to be on the US dollar?
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Economic Answer
• Benefits and Costs involved in adopting a common currency.
• The solution has to involve trading off these benefits.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
In a Nutshell
• The benefits:
– money exhibits increasing returns to scale
– the world has the way to maximise this benefit
• The costs:
– loss of monetary and exchange rate instruments
– matters in presence of:
• price and wage stickiness
• asymmetric shocks.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Focusing on Costs
• Look at the costs:
– No precise way of estimating costs and benefits so, in the end, a
matter of judgement.
• Look at asymmetric shocks:
– how they create trouble
– what makes them more likely
– what makes them less painful.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
A demand shock
• Simplest example: an adverse demand shock: how can the
exchange rate help?
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Asymmetric Shock in currency union (currency
depreciates)
EPA/P*
EPB/P*
S
λo
λ2
S
A
A’
A
C’’
C’
C’’
C’
B’
B
B’’
λ1
D’
Country A
0
Output Gap
D
D
D’
Country B
0
Output Gap
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Asymmetric Shock
• After an assymetric show moving demand for country A from
D to D’
– Country A wants a depreciation according to a new equilibrium
B, and real exchange rate λ1
– Country B unhappy, as for the same real exchange rate it faces
inflationary excess demand BB’
– However, with unchanged real exchange rate λ1 country A faces
excess supply AA’
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Asymmetric Shock in currency union (currency
stays put)
EPA/P*
EPB/P*
S
λo
λ2
S
A
A’
A
C’’
C’
B’
B
λ1
D’
Country A
C’’
C’
0
Output Gap
B’’
D
D
D’
Country B
0
Output Gap
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Implications of Asymmetric Shocks
• Both countries are hurt when they share the same currency.
• This is an unavoidable cost.
• Next questions:
– what reduces the incidence of asymmetric shocks?
– what makes it easier to cope with shocks when they occur.
• The analysis develops six OCA criteria.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Six OCA criteria
• Three classic (economic) criteria
– Mundell
– Kenen
– McKinnon
• Three political criteria
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 1 (Mundell): Labour Mobility
In an OCA labour moves easily across national borders.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 1 (Mundell): Labour Mobility
• Caveats:
– labour mobility is easy within national borders (culture, language,
legislation, welfare, etc.)
– capital mobility: difference between financial and physical capital
– in presence of country specialisation, skills also matter.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 2 (Kenen): Production Diversification
• Countries whose production and exports are widely diversified
and of similar structure form an OCA.
– Indeed, in that case, there are few asymmetric shocks and each of
them is likely to be of small concern.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 3 (McKinnon): Openness
• Countries which are very open to trade and trade heavily
with each other form an OCA.
• Distinguish between traded and nontraded goods:
– traded good prices are set worldwide
– a small economy is price-taker, so the exchange rate does not
affect competitiveness.
• If all goods are traded, domestic good prices must be
flexible and the exchange rate does not matter for
competitiveness.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 4: Fiscal Transfers
• Countries that agree to compensate each other for adverse shock
form an OCA.
• Transfers can act as an insurance that mitigates the costs of an
asymmetric shock.
• Transfers exist within national borders:
– implicitly through the welfare system
– explicitly in federal states.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 5: Homogeneous Preferences
• Countries that share a wide consensus on the way to deal with
shocks form an OCA.
• Matters primarily for symmetric shocks:
– prevalent when the Kenen criterion is satisfied.
• May also help for asymmetric shocks:
– better understanding of partners’ actions
– encourages transfers.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Criterion 6: Commonality of Destiny
• Countries that view themselves as sharing a common destiny
better accept the costs of operating an OCA.
• A common currency will always face occasional asymmetric
shocks that result in temporary conflicts of interests:
– this calls for accepting such economic costs in the name of a higher
purpose.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Is Europe An OCA? (Asymmetric shocks)
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Is Europe An OCA? (Diversification and
dissimilarity)
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Is Europe An OCA? (Openness)
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Inside the OCA Index: Labour Mobility
• Low internal EU labour mobility
• EU must factor in many migration costs:
–
–
–
–
–
–
–
–
moving costs
risk of becoming unemployed
longer run career opportunities
family prospects
eligibility to welfare
taxation
cultural/linguistic differences
national attachment.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Inside the OCA Index: Transfers
• The EU does not satisfy the transfer criterion.
• The overall EU budget:
– is low, slightly over 1% of EU GDP
– entirely used for administration, CAP, regional and structural funds.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Inside the OCA Index: Homogeneity of
Preferences
• Little is known about this criterion.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Inside the OCA Index: Solidarity vs Nationalism
• Little is known about this criterion.
• Tendency of new member states to support joint decision-making
more than Nordic countries
• Nationalism does not overall exert powerful influence.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Overall
• The OCA glass is half full, or half empty.
•
Living in a monetary union may help fulfill the OCA criteria over
time.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Will Trade Deepen?
• Mounting evidence that eliminating exchange rate volatility
by adopting a common currency raises trade a lot:
– Baldwin et al (2008) shows euro to have increased trade by 5%
so far
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Will Diversification Grow or Decline?
• Argument 1: intra-industry trade will grow.
• Argument 2: specialisation will increase.
• No firm conclusion so far.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
EMU and Labour Markets
• Mobility may not change much, as labour markets remain
rigid with unemployment protection
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Are the Other Criteria Endogenous?
• Transfers:
– currently no support for more taxes of finance transfers.
• Homogeneity of preferences and Commonality of destiny:
– no presumption that it will change soon.
In the end:
Monetary union is not only about economics!
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
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