OPTIMAL OPTIMAL CURRENCY CURRENCY

AREA IIAREA IIWEEK 3WEEK 3

Chapter 2 and 3Chapter 2 and 3Chapter 4 (reading)Chapter 4 (reading)

Lecture planLecture plan• 1. Analysing monetary union costs:

how effective are national macroconomic policies?

• 2. The benefits of a single currency

The effectiviness of national The effectiviness of national macroeconomic policiesmacroeconomic policies

• Monetary and exchange rate policies’job is to offset shocks

• a) permanent• b) temporary• Monetary policy (decrease in i, and subsequent

decrease in E under flexible exchange rate regime)

• =• Exchange rate policy (decrease in E under fixed

exchange rate regime)

PermanentPermanent shock shock• Permanent shift in demand from French to

German products.• If France doesn’t want (or is not in the

position) to wait for the necessary supply adjustment to occur, then it can implement expansionary monetary/exchange rate policy to shift back AD curve.

• Devaluation raises imports prices, and shifts AS curve leftward (even further away if wage-setting process is such that)

• In the long-run, expansionary policy will not restore the original equilibrium

• Once again, we notice that the “devil” lies in the aggregate supply dynamics through the labour market.

• Devaluation drug.• What would be the situation in a monetary union?• In both cases, after a permanent demand shock,

France has to be willing to accept a decline in the real wage (either through AS rightward shift, or devaluation)

• Maybe it can be more politically sustainable, but economically speaking it all comes down to that.

TemporaryTemporary shock: the Barro- shock: the Barro-Gordon modelGordon model

• When we face a temporary shock, we are in the classic macroeconomic situation (stabilization policy).

• Here we have a classic anti-euro argument: if France is hit negatively and Germany positively, under a monetary union ECB should do nothing (the two shocks offset each other)

• Instead, under national macroeconomic policies, each country can best pursue its own stabilization policy.

• How effective are these national stabilization policies?

Barro-Gordon in wordsBarro-Gordon in words• Before Barro-Gordon: a country can choose its

most preferred combination on the inflation-unemployment frontier

• Do you wanna have less unemployment….? You just have to bear some more inflation (brought about by AD shifts, due to macroeconomic policies).

• The crucial role of expectations: expectations matter. High inflation today means that people will expect high inflation tomorrow, and this will actually bring about more inflation tomorrow.

• Phillips curve (negative relationship between inflation and unemployment) is not stable.

• Whatever increases inflation expectations moves Phillips curve upward

• And what would that be…? Inflation!• If I push aggregate demand up today, I will

absorb more inflation at the expense of more inflation.

• But this additional inflation won’t stop here…..it will increase inflation expectations for tomorrow, and this will actually increase inflation tomorrow, even if unemployment does not move.

• There is an independent (=not unemployment) reason why inflation can raise…..inflation expectations!

• In the long-run there is no trade-off to be exploited between inflation and unemployment…..sooner or later, you will find yourself on a vertical line (long-run Phillips curve)

• So it’s not true that a country (outside a monetary union) is free to choose its most preferred combination. Unemployment equilibrium level is pinned down by the natural level (=potential leve ) of output

• In the long-run.• ….maybe we can still rely on the short-run?• (skip 2.4, we’ll save it for later)

• Monetary policy is useless if used in a discretionary way; the more rational expectations are, the more useless monetary policy is.

• The key is that the private sector is aware of monetary policy’s “incentive to cheat”, and act accordingly.

• The result of the process is that inflation rate will be higher than the one announced by central bank.

• How does it happen?

The process in stepsThe process in steps• 1) CB announces =0.• 2) Private sector knows that once they fix their

nominal variables (w and p) based on CB’s announcement, CB will have anyway the incentive to reduce unemployment at the expense of more inflation (surprise inflation). In that case, private sector will suffer of a reduction in purchasing power.

• 3) Based on 2), private sector will increase their inflation expectations, and this will actually increase (Phillips curve shifts upward).

• 4) The process ends only on the vertical Phillips curve, where inflation expectations are met.

The hijackingThe hijacking

• 1) A given country announces that in case of hijacking it will never negotiate.

• 2) A hijacking does occur, with 200 hostages, and ask for a small ransom. What’s the optimal action by authorities? To give in, and save 200 lives.

• 3) Knowing 2), terrorists around the world won’t believe further announcements by government, and will be incentived to hijacking.

What’s the solution?What’s the solution?

• Never negotiate. Gain the necessary credibility so to curb any expectations by terrorist.

• Be credible. Persuade the public that, no matter what, CB will never implement “surprise inflation” (i.e. it will never try to exploit the short-run trade off to reduce unemployment below the natural level).

So what are we saying?So what are we saying?• 1) Inflation-unemployment trade off does not

exist in the long-run, due to AS shifts (increase in production costs)

• 2) Inflation-unemployment trade off might not even exists in the short-run, due to private sector expectations and lack of credibility by CB (private sector is aware of CB’s incentive to deviate from zero inflation announcement, and thus update inflation expectations). As a result, inflation will be inefficiently higher.

• A solution to 2), is to “tie CB’s hands”: make them independent from political power and credible.

• Bank of Italy’s “divorce” (1978)• Volcker (1979)• Bundesbank• Bank of New Zealand• Bank of England (1997)• ECB (1999)

• All round the world, CB realized that establishing a sound reputation of credibility (“I will stick to my inflation goal and won’t try to “cheat” once inflation expectations are formed”).

In open economyIn open economy

• Proceeding with out initial analogy, just replace “inflation rate target” with “exchange rate target”

• CB can exploit the trade-off by creating surprise inflation (by pursuing expansionary monetary policy)

• as well as• creating surprise devaluation

• In both cases we’re talking about expansionary macro policies that won’t

accept the natural level of output and try to push the economy above it.

• Do you mean that if an economy is featured by low potential output growth it should just learn to live with it?

• No.• Just solve the problem with adequate means.

• Raise the potential growth (non-inflationary growth).

• Total factor productivity (R&D, human capital, innovation,technology, social and economic infrastructure, stability, protection of property rights….whatever helps capital and labour do their job)

• Increase in labour force (participation in the labour market).

• If you can’t do that (because it’s too hard and/or it takes too long), you are surely tempted to raise output growth simply by “injecting drugs”:Expansionary monetary/exchange policy

• But this won’t bring you any benefits in the long-run (output goes back to its natural level with higher prices), and not even in the short-run (price setting by private sector will take into account CB opportunistic behaviour).

• Economics has never historically agreed on the speed of the latter process (monetarists: it happens instantaneously. Keynesians: it happens very slow because of nominal variables rigidities).

• But they agree on the fact that it does happen, sooner or later.

• So we found out that macroeconomic policies need to be handled carefully.

• If they are used to push output above potential, they are damaging. So in this respect, countries forming a monetary union loose a dangerous temptation.

• But we still have a powerful argument to fight……what if they are used against shocks? Would then be a more significant loss?

CB reaction to supply shockCB reaction to supply shock• When a supply shock occurs, Phillips curve shifts

rightward (i.e. more inflation for any given level of output).

• Then we face the macroeconomic policy dilemma (Week 1):

• do I stabilize unemployment/output (at the expense of more inflation)?

• or do I stabilize inflation? (at the expense of more unemployment/less output)

• The choice depends essentially on CB’s preferences.

a) If CB cares a lot about employment (i.e. attach a relatively high weight to employment stabilization), the resulting inflation bias will be higher

b) If CB cares a lot about inflation (i.e. attach a relatively hight weigh to inflation stabilization) then inflation will be stabilized at the expense of more unemployment.

…..don’t you think it should be countries’ business?

• a) Inflation is bad. Don’t forget that. Supply shocks are indeed very hard to deal with, but there is a way to do that without worsening inflation: facilitate market adjustment (wage moderation, costs reductions, technology improvement)

• b) If you don’t believe a)……. Remember the three prices of money……..if we harmonize two of them (interest rate, exchange rate) we’ll have to deal with the third one as well (inflation rate).

• And if we have to do that, we should harmonize the ultimate determinants of inflation bias……..

• Different central banks’preferences.

SUMMING UP ON M.U.COSTSSUMMING UP ON M.U.COSTS

• They are not as evident as they looked at first sight, aren’t they?

• Asymmetric shocks (at the heart of OCA theory) are not likely.

• Countries are indeed different in some aspects (labour market, financial market) that can play a role in increasing divergence after a shock. But:

a) Are we saying that countries must be equal in all respects to be able to form a monetary union?

b) Further integration step will (have to) harmonize those differences

• Countries are not really free to choose their most preferred combination of inflation-unemployment trade off, because in the long-run there is simply no trade off

• And in the short-run?• If macroeconomic policies are used to push ouput

above potential: then loosing them (by joining a monetary union) is a good thing.

• If macroeconomic policies are used to offset asymmetric supply shock: then if we want to create a single currency we also have to harmonize inflation, and thus we have to harmonize CB’s preferences on inflation (and remember that inflation is bad). But what are asymmetric supply shocks?!?!?!

• If macroeconomic policies are used to offset asymmetric demand shock:

• Go back to point 1): how likely they are• All right, all right…..theoretically, this is indeed a

true cost of a monetary union.

• But what about the benefits?

The benefits of a single The benefits of a single currencycurrency

• Macroeconomic costs.• Microeconomic benefits. a) elimination of transaction costs b) elimination of exchange rate risk c) international currency

a1)Directa1)Direct benefits from elimination of benefits from elimination of transaction coststransaction costs

• It is the most visible (although less quantifiable) gain from a monetary union.

• We might try to quantify the benefits in terms of commissions, and so on….

• But we know the most important issue here…..without the single currency, all the previous integration steps would have been meaningless (supermarket with different currencies).

• Which leads us to….

a2)Indirecta2)Indirect benefits from elimination of benefits from elimination of transaction coststransaction costs

• Price transparency• Goods and services prices are easily comparable

across the Union.• This effect is greater the more competition we

have in the single market (link with Andrea Mantovani’s course).

b) No exchange rate riskb) No exchange rate risk

• Uncertainty about the future value of exchange rate (under a flexible regime) can have severe consequences on:

• a) trade• b) investment (real and financial)• c) growth• d) consumption (through imports)• So why don’t you adopt a fixed exchange rate regime?• The required macroeconomic harmonization (“the three

prices of currency”) is impossible under free movement of capital (“second floor” of the European integration).

c) international currencyc) international currency• Creating a new currency which is likely to be

adopted outside the area has two types of benefits:

• a) Balance-sheet of CB increases (and decreases passivity on balance of payment capital account)

• b) financial market expands (week 10)

Costs vs Benefits (read ch.4)Costs vs Benefits (read ch.4)• No doubt the greater cost of forming a monetary

union is the lost of national macroeconomic stabilization policies after asymmetric demand shocks.

• This remark can surely be mitigated by the deeper analysis we carried out on aggregate demand management. But it still remains.

• Benefits are also noteworthy: all the advantages from having a common market cannot be fully exploited without a single currency.

• And don’t forget the foundations of the building.

NEXT WEEKNEXT WEEK• What we know:• a) What is EU integration• b) What is macroeconomic policy and how it

works• c) Costs (lost of most national macro tools)

and benefits (micro benefits and full integration) of a monetary union

• What we’ll talk about next week:• Since EMU means having a single central bank…

how does ECB work?