Chapter 4:
Costs and Benefits Compared
De Grauwe:
Economics of Monetary Union
Costs and Benefits (% GDP)
Costs and benefits of a
monetary union
Benefits
Costs
Trade (% GDP)
Two views about costs and benefits
of MU
(a) The monetarist view
Benefits
Costs and benefits
Costs and benefits
Benefits
(b) The Keynesian view
Costs
Costs
T*
T*
Trade (% GDP)
Trade (%GDP)
Two views about costs of MU
• The 'monetarist‘ view :
– Monetary policies are ineffective as instruments to
correct for different developments between
countries
– The cost curve is close to the origin
– Thus, many countries in the world would gain by
relinquishing their national currencies, and by
joining a monetary union
• The 'Keynesian' view:
– The world is full of rigidities
– Monetary policy (including exchange rate policy) is
a powerful instrument in eliminating disequilibria
– The cost curve is far away from the origin
– Relatively few countries should find it in their
interest to join a monetary union
• Since the early 1980s the 'monetarist' view
has gained adherents, and has changed the
view many economists have about the
desirability of a monetary union
• The popularity of monetarism helps to explain
why EMU became a reality in the 1990s
Costs and benefits
Costs and benefits with decreasing
rigidities
Benefits
Costs
T*
T**
Trade (% GDP)
•With decline in wage and
price rigidities and an
increase in labour mobility:
•Cost curve shifts
downwards
•Monetary union becomes
more attractive
Is EMU an optimal
currency area?
• In order to answer to this question there are
different parameters to evaluate:
– Intra-EU trade
– Degree of rigidities
– Degree of asymmetry of shocks
Table 4.1: Intra-union exports of EU countries (% of GDP) in 2005
Belgium/Luxembourg
Slovakia
Czech Republic
Netherlands
Estonia
Hungary
Slovenia
Ireland
Lithuania
Austria
Latvia
Denkmark
Poland
Germany
Sweden
Malta
Finland
Portugal
France
Italy
Spain
United Kingdom
Cyprus
Greece
66,7
58,9
54,1
51,1
45,6
43,7
37,3
34,7
30,1
28,1
24,6
23,1
23,1
22,0
21,2
21,0
19,1
16,6
13,7
12,2
12,0
9,8
6,1
4,0
•
•
•
Large differences in openness
of EU countries with the rest of
the Union
For countries with a small
degree of openness (UK and
Greece), it is less clear that
they belong to an optimal
currency area with the rest of
the EU
Cost-benefit analysis is likely to
show net benefits of being in
EMU for Benelux, and small
central European countries
Asymmetric shocks and labour
market flexibility
• Not only the degree of labour market flexibility
which matters for determining whether a
monetary union will be attractive to countries
• Also asymmetry in demand and supply shocks
matters
• There is a link between labour market flexibility
and asymmetric shocks in a monetary union
Asymmetric shocks and labour market
flexibility in monetary unions
Symmetry
• Eurozone
• EU-25
• USA
OCA
Flexibility
•Downward sloping OCA-line
shows minimum combinations of
symmetry and flexibility that
countries must have in order for a
monetary union to provide more
benefits than costs
•Countries or regions located
below the OCA line do not have
enough flexibility given the level
of symmetry they face
•Countries to the right of the OCA
line have a lot of flexibility given
the level of symmetry they face
•Evidence about how many
countries in EU form OCA is not
clear-cut
• The challenging task for the EU-25 is to move
to the other side of the OCA-line, i.e. to make a
monetary union less costly
• How can this be achieved? There are
essentially two strategies:
– Reduce the degree of real divergence (political
union)
– Increase the degree of flexibility of labour markets
Costs and benefits in the long run
The European Commission view of monetary integration
•Upward sloping line (TT) because as
trade integration increases the
degree of symmetry between the
countries involved declines
•Downward sloping line (OCA):
Symmetry
T
EU-25
T
OCA
Trade integration
•Less symmetry makes a monetary
union more costly. More integration
reduces the costs of a monetary
union. Thus a reduction in symmetry
must be compensated by more
integration to make a monetary
union worthwhile (in terms of costs
and benefits)
•Points on OCA line are minimal
combinations of symmetry and
integration for which monetary union
has zero net gain
Costs and benefits in the long run
The pessimistic view of monetary integration
Symmetry
T´
T
EU-25
T
T´
Trade integration
OCA
• Two possibilities for the long-term prospects of
monetary union:
– One is represented by the TT line. In this case,
although today the EU-25 may not be an optimum
currency area, it will move into the OCA zone over
time (right side of OCA)
– The second case is represented by the steep T’T’
line. Integration brings us increasingly farther away
from the OCA zone. The net gains of a monetary
union do not increase fast enough with the degree of
integration. Thus, the costs of asymmetry overwhelm
all the other benefits a monetary union may have
– Second case is implausible
Endogeniety of monetary union
• A decision by an individual country to join
EMU, even if it does not satisfy the OCA
criteria, can have a self-fulfilling character
• In this case the process of integration is sped
up by the very decision to join the monetary
union, so that this new country grouping
moves faster into the OCA zone
• OCA becomes endogenous
The challenge of
enlargement of EMU
• Two challenges
– Enlargement poses problems for the 12 present
members
– Enlargement poses problems for the newcomers
Is Euro-25 OCA?
Openness as a criterion
Figure 4.11: Exports of goods and services towards EU-25 as percentage of GDP (2005)
80
70
60
40
30
20
10
Countries
ESP
PRT
NLD
ITA
IRL
GRC
DEU
FRA
FIN
BEL/LUX
AUT
UK
S
DK
SVN
SVK
POL
MAL
LTU
LVA
HUN
EST
CZE
0
CYP
Exports
50
• The central European countries are as open
towards the EU as the EU-countries
themselves
• The central European countries appear to be
more integrated with the EU than Denmark,
Sweden and the UK
Is Euro-25 OCA?
Asymmetry of shocks
Correlation of demand and supply shocks with Euro area
0,8
0,6
ITA
demand shocks
0,4
POL
ESP
0,2
IRL
ROM
0
DK
GR
SVK
CZE
-0,2
S
FRA
HUN
EST AUT
FIN
GER
PRT
NLD
BEL
UK
SVN
-0,4
LTU
-0,6
-0,2
LVA
0
0,2
0,4
supply shocks
0,6
0,8
•Each point represents
correlation between
demand and supply
shocks of particular
country with EU-average
•Many CE-countries’
demand shocks
negatively correlated with
EU demand shocks
•Low correlation of supply
shocks between CEcountries and EU
•Asymmetries in demand
shocks may disappear
partly in MU, asymmetries
in supply shocks more
likely to stay
• Thus, not all CE-countries may be part of an
optimal currency area with the rest of the
European Union
– Despite relatively large openness of the CEcountries vis a vis the EU, many are subjected to
relatively large asymmetric shocks, so that it is not
obvious that they would gain from entering EMU
• However, for some of these countries entering
EMU might be the best possible way to import
monetary and price stability
How will present members be
affected by enlargement to Euro-25?
symmetry
Eurozone
EU-25
OCA
• Euro-25 more subject to
asymmetric shocks than
Eurozone
• Original members of
Eurozone (who are also part
of Euro-25) are thrown out of
OCA-zone
• Some original members will
perceive policies of the ECB
to be less receptive to their
domestic shocks than prior
to enlargement
Economic integration
Is Latin America an
optimal currency area?
• Monetary instability has made the idea of
forming a monetary union in Latin America
popular
• Costs of monetary union in Latin America
– Latin American countries have very low levels of
trade with the rest of Latin America
Figure 4.16: Intraregional exports of goods and services, EU and Latin
America as a percentage of GDP (2005)
80,0
70,0
60,0
40,0
30,0
20,0
10,0
Countries
PRT
NLD
ITA
IRL
GRC
FRA
FIN
ESP
DEU
BEL/LUX
AUT
Bolivia*
Paraguay
Uruguay
Chile
Brazil
0,0
Argentina
Exports
50,0
– Degree of synchronization of output movements is
low in Latin America, and asymmetric shocks are
relatively large
– Very little empirical evidence has been undertaken
to measure the degree of flexibility of labour
markets
• Main driving force for popularity of MU is the
hope to import price stability
• If monetary union comes about it will have to
provide the right institutions guaranteeing
price stability
Is East-Asia an optimal
currency area?
Interregional exports of goods and services, East-Asia and EU
as % of GDP (2003)
135
100
90
80
70
exports
60
50
40
30
20
10
0
ESP
PRT
NLD
ITA
IRL
GRC
DEU
FRA
FIN
BEL/LUX
AUT
SIN
THAI
PHIL
MAL
KOR
HK
CHINA
Source: IMF, IFS and
Xu Ning(2004)
Note: the exports of
the East-Asian
countries is to ASEAN
plus China, Korea and
Japan. The data for
China relate to 2001.
Shocks are not more asymmetric in
Asia than in Eurozone
Percent of demand and supply changes explained by common shock
100%
90%
Eurozone
Percent of demand and supply changes explained by common shock
70%
60%
100%
supply
90%
80%
30%
70%
40%
30%
20%
10%
av
er
ag
e
Sp
ai
n
Ita
ly
Ne
th
er
la
nd
s
Po
rtu
ga
l
0%
Ire
la
nd
av
er
ag
e
Th
ai
la
nd
demand
Fr
an
ce
G
er
m
an
y
G
re
ec
e
Asia
Ta
iw
an
Ph
ilip
pi
ne
s
Si
ng
ap
or
e
al
ay
sia
M
Ko
re
a
Ja
pa
n
In
do
ne
sia
Ko
ng
Ch
i
na
0%
supply
50%
nl
an
d
10%
60%
Au
st
ri
20%
percent common shock
40%
Fi
demand
a
Be
lg
iu
m
50%
Ho
ng
percent common shock
80%
• Economic conditions for monetary union in
East Asia seem to be satisfied
• Main stumbling block is political
• Desire for political unification is weak
• Contrast with Europe is great: process of
political unification in Europe has been going
on since 1960
Monetary Unions in Africa
• There is a history of monetary union in Westand Central Africa
• Legacy of colonization: CFA-zone
• New initiative to extend existing monetary
unions: The Economic Community of WestAfrican States (ECOWAS)
• This is a grouping of 15 states
• Do these form an OCA?
0
PRT
NLD
ITA
IRL
GRC
FRA
FIN
ESP
DEU
BEL/LUX
AUT
Togo
Sierra Leone
Senegal
Nigeria
Niger
Mali
Liberia
Guinea-Bissau
Guinea
Ghana
Gambia, The
Côte d'Ivoire
Cape Verde
Burkina Faso
Benin
Figure 4.20: Intraregional exports of goods and services in West-Africa
(2003) and the Eurozone (2005)
80
70
60
50
40
30
20
10
• When using the Eurozone as a benchmark,
the evidence on whether West Africa forms an
optimal currency area is mixed:
– The degree of integration among West African
countries is low, yielding relatively few benefits of a
monetary union
– Labour mobility is substantially stronger
– The degree of asymmetry does not seem to be larger
in West Africa than it is in the Eurozone
– West African countries (the members of WAEMU)
have already set into place a series of institutions,
such as a common central bank facilitating further
steps towards a monetary union
Conclusion
• It is unlikely that the EU as a whole constitutes an
optimal monetary union
• As integration moves on, the number of countries
that are likely to benefit from monetary union will
increase
• Enlargement of the Eurozone to 25 countries
creates serious challenges
– Euro-25 is probably not an OCA, but may become
one
– Enlargement will change the cost benefit calculus of
existing members of the Eurozone. Some of these
member countries may find out that the enlargement
makes the monetary union less attractive
• It is unlikely that Latin America and East Asia will
come to monetary union soon, although reasons
are different
• Evidence about West-Africa as an OCA is mixed
• Our analysis has been based on an economic
cost-benefit analysis. Countries may also decide
to adopt a common currency for political reasons
• The economic cost-benefit analysis remains
useful, because it gives an idea of the price some
countries will have to pay to achieve these
political objectives