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International finance 120181-1165
The optimum currency area theory
International finance 120181-1165
Lecture outline
The Mundell, McKinnon and Kenen models
The „new” OCA theory
The comparative approach
The endogeneity of OCA
International finance 120181-1165
The Mundell model
Assumptions
two countries
full employment
BP in equilibrium
short term price and wage rigidity
International finance 120181-1165
The Mundell model
Demand shock analysis
Two cases: different currencies in two countries
currency union
International finance 120181-1165
The Mundell model
Demand increases for country A products
Demand decreases for country B products
Inflationary pressures in country A,
unemployment growth in country B
If countries use separate currencies ER
adjustments
International finance 120181-1165
The Mundell model
In case of a currency union: Expansionary monetary policy in country B
causes inflationary pressures in country A
Worsening of terms of trade in country A
versus country B
The need to adjust demand shocks by other
means than ER- labour force mobility
International finance 120181-1165
The Mundell model
Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000
International finance 120181-1165
The Mundell model
Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000
International finance 120181-1165
Modifying assumptions
Modifying the assumption of price and
wage rigidity new adjustment
instruments
Labour market flexibility
International finance 120181-1165
Adjustment through prices and wages changes
Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000
International finance 120181-1165
Conlusions from the Mundell model
If two economies characterized by price
and wage rigidity want to introduce a
currency union they should ensure labour
force mobility
International finance 120181-1165
The McKinnon model
The comparison of the utility of two instruments
reinstating the external equilibrium depending on
the openness of the economy : Flexible ER
Internal monetary and fiscal policy
The openness of the economy – the ratio of
tradable and nontradable products in the
production and consumption structure
International finance 120181-1165
The McKinnon model
Assumptions:Two economies - different openness
No factor mobility
International finance 120181-1165
The McKinnon model
An open economy Flexible ER as a mean of maintaining the
external equilibrium
Growing demand for tradables current
account deficit
International finance 120181-1165
The McKinnon model
Devaluation price increase of the imported
goods vs. nontradables supply growth of
tradables and demand growth for nontradables
BP equilibrium reinstated
but
the tradables price increase is permanent
International finance 120181-1165
The McKinnon model
External equilibrium reinstatement by
contractionary fiscal policy
Influence on employment???
The effect of BP improvement outperforms the
effect of employment reduction depending on
the grade of openness
International finance 120181-1165
The McKinnon model
A less open economy
Demand grows for tradables current account
deficit
Devaluation price increase of the imported
goods vs. nontradables supply growth of
tradables and demand growth for nontradables
BP equilibrium reinstated
International finance 120181-1165
The McKinnon model
Contractionary fiscal policy the
influence mostly on the nontradables
sector
High share of nontradables
unemployment increase
International finance 120181-1165
The McKinnon model
Source: Own elaboration based on: K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006
Y
PAD’
KW x P
AD
AS
C
BA
Y
P
AD’AD
AS
AD’’
International finance 120181-1165
Conclusions from the McKinnon model
The higher the grade of openness of
economy the lower is the efficiency of a
flexible ER as an adjustment tool and the
higher is its negative influence on price
stability
International finance 120181-1165
The Kenen model
Assumptions: Two economies with different production structure
diversification
Factor mobility
Demand shocks analysis
International finance 120181-1165
The Kenen model
Demand shock internal equilibrium
exacerbated
The effect on external balance depends
on the grade of diversification
Higher diversification shocks concern
only a part of the production/exports
International finance 120181-1165
Conclusions from the Kenen model
Countries can create a currency union
provided a diversified export structure is
ensured
An economy with higher production
diversification does not have to use the ER
as adjustment tool as often as a less
diversified economy
International finance 120181-1165
The optimalisation criteria deriving from the „old” theory
factor mobility
labour market flexibility
the openness of the economy
production diversification
International finance 120181-1165
The drawbacks of the „old” theory
Rigid prices assumption
Demand side approach
The only cost of monetary integration is the loss
of ER as adjustment instrument
Consideration of the cost of monetary
integration, the advantages are neglected
International finance 120181-1165
„The „new” OCA theory
Keynesian assumptions rejected
Ingram (1969)- integration of financial markets
Haberler (1970) and Fleming (1971)- inflation rates
similarity
Corden (1972) and Giersch (1973)- inflation preferences
similarity
International finance 120181-1165
Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,
International finance 120181-1165
Opracowanie własne na podstawie P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,
International finance 120181-1165
The Barro-Gordon model
Monetary policy credibility analysis after
establishing a monetary union
Rational inflation expectations
U-Un=α(Лe-Л)
International finance 120181-1165
The Barro-Gordon model
Different preferences concerning the restrictiveness of the
monetary policy
In one of the countries the CB is not credible the inflation
target is not fulfilled
Rational expectations price increase
Currency union there is only one common inflation level set by
a supranational CB
International finance 120181-1165
The Barro-Gordon model
Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,
International finance 120181-1165
Coclusions from the Barro-Gordon model
The establishment of a currency union may influence
positively the credibility of the monetary policy of a
country, which previously led an inefficient monetary
policy
The condition: the supranational CB conducts a
monetary policy designed as the policy of the country
with the lowest inflation
International finance 120181-1165
The advantages of creating a monetary
union Creating a monetary union monetary credibility
increase and the decrease of risk premium+ ER risk
elimination
A single decrease of the risk premium contributes to
production growth
Learning effects, effects of scale and additional capital
accumulation potential increase of productivity in the
long term
International finance 120181-1165
The advantages of creating a monetary union
Source: Own elaboration based on: de Grauwe, op. cit
F (k)
F’ (k)
C
B
A
y
k
r’
r
r”
International finance 120181-1165
The comparative OCA approach
Assessing the gains and losses related to
monetary unification
The Keynesian and monetarist approach
The extent of gains and losses depends
on the assessment of the ER efficiency as
adjustment tool
International finance 120181-1165
The comparative OCA approach
Source: Own elaboration based on: de Grauwe, op.cit.
International finance 120181-1165
The comparative OCA approach
Krugman’s approach vs. European
Commission’s approach
The symmetry of shocks as optimalisation
criterion
The influence of trade integration on the
symmetry of shocks
International finance 120181-1165
The endogeneity of OCA
The influence of trade integration on the
assymetry of shocks
Countries which do not fulfill the OCA criteria ex
ante may fulfill them ex psot
Empirical evidence Bayoumi and Eichengreen
(1996), Frankel and Rose (1996)
International finance 120181-1165
The endogeneity of OCA
One can not assess the fulfilment of the OCA criteria on
the base of historical data
Endogenous processes within currency unions
Positive correlation between trade intensity and
business cycle correlation
International finance 120181-1165
Source: Own elaboration based on: F. Mongelli, „New“ views on the optimum currency area theory: what is EMU telling us?, ECB Working Paper no. 138, ECB, Frankfurt am Main 2002,
The endogeneity of OCA
International finance 120181-1165
Summing up
Some of the OCA criteria: Factor mobility
Labour market flexibility
The openness of the economy
Production diversification
Symmetry of shocks
Financial integration
Similarity of inflation levels
International finance 120181-1165
Summing up
„The old” and „the new” OCA theory
The assesmesnt of the ER efficiency as
an economic policy tool
The comparative approach- Krugman vs.
EC
The endogeneity of OCA
International finance 120181-1165
References
A. Alesina, R. Barro, Currency unions, Quarterly journal of Economics, 2002
T. Bayoumi, The formal model of optimum currency areas, IMF Staff Papers, vol. 41, 1994,
T. Bayoumi, B. Eichengreen, Ever closer to heaven? An optimum currency area index for European countries, European Economic Review no.41, 1997
J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000
J. Frankel, A. Rose, The endogeneity of the optimum currency area criteria, NBER Working Paper, Cambridge 1996
International finance 120181-1165
References
P. De Grauwe, Economics of monetary union, Oxford University Press, 2007.
P. Kenen, The theory of optimum currency areas: an eclectic view w: Monetary problems of the international economy, The University of Chicago Press, Chicago & London 1969
R. McKinnon, Optimum currency areas, The American Economic Review vol. 53, 1963
R. Mundell, A theory of optimum currency areas, The American Economic Review vol. 51, 1961
K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006