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2. The Euro Zone as an Optimum Currency Area

Costs and Benefits of a Monetary Union

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OCA Theory: Definition and Evolution

Pioneered by Mundell (1961), McKinnon (1963) and Kenen (1969)

First stream (60s-70s) focussed on the cost side of the cost-benefit analysis of a monetary union (MU)

Objective: to identify crucial economic characteristics required for a country to be an optimal member of a MU

Second stream (70s-till now) focussed on the analysis of costs and benefits for countries intending to participate in a MU

More recent evolution: the endogeneity of the OCA criteria (Frankel & Rose, 1996)

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2.1. The Benefits of Joining a Monetary Union (MU)

Elimination of transaction costs Direct gains from elimination of

costs to exchange currencies (EC estimates between 13 and 20 billion euro per year)

Indirect gains from price transparency (but see Table 3.1)

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2.1. The Benefits of Joining a Monetary Union (MU) Less uncertainty due to elimination of exchange

rate risk (reducing uncertainty in the price system and negative consequences on the allocation of resources)

Less uncertainty increases trade between countries. A. Rose (2000) found that trade flows between countries which form a MU are on average 100 % higher.

Beneficial impact of less uncertainty on growth (reduction of real interest rate, temporary increase in the growth rate, higher output level per capita in equilibrium).

Moreover, Frankel and Rose (2002) found that 1 per cent increas in trade leads to increase of per capita GDP of one third of a percantage point.

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2.2. The Costs of Joining a MU?

Joining a MU means relinquishing an instrument of economic policy (no independent monetary policy)

Use of the exchange rate as a policy instrument is not possible any more

Structural differences between countries could make it costly to give up this instrument

We now examine: (1) Mundell’s model of a demand shift; (2) insurance mechanisms against asymmetric shocks; (3) differences in labour market institutions

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(1) Mundell’s model: a brief description

2 countries (France and Germany) form a MU Starting point: asymmetric shock in aggregate

demand (change in consumers’ preferences) Upward movement of demand curve in DE and

downward movement of demand curve in FR Result: output declines and unemployment

increases in FR and opposite happens in DE Crucial question: are there mechanisms leading

automatically back to equilibrium?

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A graphical representation

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The adjustment mechanisms Automatic adjustment through wage

flexibility: wages decrease in FR and increase in DE (shifting the supply curves) (and causing second-order effects of wage and price changes on aggregate demand)

Automatic adjustment through labour mobility: unemployed workers move from FR to DE (removing pressures on labour markets: no change in wages)

If downward rigidity of wage in FR and no movement of labour: adjustment occurs through inflation in DE, making French goods more competitive

Adjustment through devaluation/revaluation in case FR and DE are not in MU (shift in demand curves back to initial position)

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A graphical representation

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Conclusions

Harder to adjust to asymmetric demand shocks for countries in a MU in case of wage rigidity and limited labour mobility

The exchange rate could add flexibility in this overly rigid system

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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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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.

In the limit, if all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness.

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Insurance against asymmetric shocks in a MU

Mechanisms for income transfers between countries in a MU make asymmetric shocks less painful (reducing the cost of the MU)

Should not prevent adjustment through wage flexibility and labour mobility, especially in case of permanent asymmetric shocks (issue of sustainability of permanent transfers)

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Public insurance schemes

1st option: public insurance system through a centralized federal budget (adjustment eased through taxes and transfers)

Not present in the EU (budget is 1.4% of EU GDP). See Table B1.1 for an example in Germany

2nd option: national budgets for countries in MU and adjustment through national government budget deficits and government debt (issue of sustainability of public debt)

In 1st option inter-regional transfers; in 2nd option inter-generational transfers

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Conclusions

Asymmetric shocks in a MU require wage flexibility and labour mobility

Insurance mechanisms help but cannot substitute the adjustment process (esp. for permanent shocks)

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Differences in labour market institutions

A different degree of centralization of wage bargaining across countries in a MU can lead to divergent wage and price developments

Popular analysis by Bruno and Sachs (1985)

Idea: centralization of wage bargaining gives no incentive to excessive wage claims (inflationary effects of wage increases are internalized)

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Bruno & Sachs more in detail

In case of supply shock and centralized wage bargaining the trade unions realize that the loss in real wage cannot be compensated by nominal wage increases (leading to more inflation)

In case of supply shock and less centralized wage bargaining each union (representing small fraction of labour force) has incentive to increase the nominal wage of its members (free-riding)

Result: decentralized system (non-cooperative game) leading to higher nominal wage level than the centralized system (cooperative game)

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Conclusions

The degree of centralization of wage bargaining affects the evolution of wages and prices

Even in presence of the same supply shock different countries can display a different impact on the price level

Costs of a MU tend to be higher for countries with very different labour market institutions

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2.2.4. OCA Theory: a Critical

Approach

Three crucial questions:• 1. Are the mentioned differences

between countries really important?• 2. Is the exchange rate really

effective in correcting for these differences?

• 3. Is the exchange rate a “dangerous” policy instrument in the hands of the politicians?

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2.2.4. OCA Theory: a Critical

Approach

Three crucial questions:• 1. Are the mentioned differences

between countries really important?

• 2. Is the exchange rate really effective in correcting for these differences?

• 3. Is the exchange rate a “dangerous” policy instrument in the hands of the politicians?

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Likelihood of asymmetric demand shocks in a MU

Two different views: the European Commission view and Krugman view

EC view: asymmetric shocks will occur less frequently in a MU (integration leads to more IIT, thus more symmetric effects of demand shocks)

Krugman view: asymmetric shocks will become more frequent in a MU (integration leads to more regional concentration of industrial activities, thus sector-specific shocks tend to become country-specific shocks)

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EC’s view versus the Krugman’s view

EC’s View

Krugman’s View

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(Tentative) Conclusions

Results are thus controversial Presumption in favour of EC: national borders

less and less important for industrial clustering in a more integrated context (specialization at level of regions encompassing national borders)

Implication: regional asymmetric shocks rather than national asymmetric shocks

Exchange rates between national currencies unable to cope with these kinds of shocks (reduction in the costs of giving up this instrument)

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Institutional differences in labour markets

Crucial question: are these differences bound to disappear in a MU?

We can expect less pronounced differences in unions’ behaviour across countries in MU (unions are aware that there is less margin left for accommodating national policies)

But we can expect also these differences to persist for quite some time after the creation of a MU

This may lead to adjustment problems in the MU given the exchange rate has disappeared

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2.2.4. OCA Theory: a Critical

Approach

Three crucial questions:• 1. Are the mentioned differences

between countries really important?• 2. Is the exchange rate really

effective in correcting for these differences?

• 3. Is the exchange rate a “dangerous” policy instrument in the hands of the politicians?

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Devaluations as a response to asymmetric demand shocks

Mundell’s model: devaluation makes aggregate demand shift upwards

However: initial favourable effects of devaluation tend to disappear over time

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Conclusions

Giving up the exchange rate as a policy instrument implies no cost in terms of long-run analysis (the exchange rate is not effective)

There is a cost in terms of short-run analysis, given the different dynamics of the alternative policy (expenditure-reducing policy)

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2.3. Comparision between Costs and Benefits (I)

Relationship between costs and benefits of the MU and the openness of a country:

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2.3. Comparision between Costs and Benefits (II)

Gains likely to increase with the degree of openness (larger benefits from elimination of transact. costs and exchange rate risk)

Costs likely to decrease with the degree of openness (less frequent asymmetric shocks + larger negative impact of devaluation on price level)

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The endogeneity of the OCA criteria (Frankel & Rose, 1996)

Endogenous component: after countries decide to form a MU they tend to score better in terms of OCA criteria

Thus, OCA criteria may be satisfied ex post, even if they are not satisfied ex ante

For instance, entry into the MU may raise trade linkages and business cycles across countries may become more similar

Application of the ‘Lucas Critique’ (suitability of countries for a MU cannot be judged based on historical data, since economic structures likely to change in the event of MU)

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Cost – Benefit Analysis: ConclusionsCostsLoss of exchange rate as

adjustment mechanismLoss of monetary policy

independence(Partial) loss of fiscal

independenceConversion costs

∑ costs > ∑ benefits ?

BenefitsElimination of exchange

rate riskMore price transparencyPrice stabilityMore tradeLower interest rates International role of the

currencyStronger position in

international policy negotiations

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Bibliographic references Main reference:

De Grauwe, P. (2006), Economics of Monetary Union (Ch. 1-4)

Secondary reference: Zestos, G.K. (2006) European

monetary Integration, (Ch. 2)