European Economic and Monetary Integration EXAM DATE

1
European Economic and Monetary Integration EXAM
DATE

• Exam April 2
• Time 5.30 pm 7.30 pm
• Place to be announced

2
Points to Remember for Presentation

• Content
• Does the presentation address the necessary
  points?
• Are the points clear?
• Organization
• Is the presentation well prepared?
• Is the level of treatment appropriate? (Not too
  detailed or too general)
• Is the presentation easy to follow with smooth
  continuity?
• Delivery
• Is the presenter energetic and enthusiastic?
• Is the presentation well practiced?
• Presentation should have very little reading from
  notes
• Does the speaker have clear, good volume with no
  mumbling?
• Is the presentation on time? (Without need to go
  over time)

3
Points to Remember for Presentation (cont.)

• Format
• Are the presentation slides large enough to read
  without too much crowding on one slide?
• Are the visuals sufficient?
• Are appropriate graphics used?
• Any misspellings, poor grammar or misuse of
  words?
• Overall Excellence
• Out of all of the presentations you have seen
  today, was this presentation among the best, one
  of the good, one of the average or one of the bad
  presentations?

4
Different Fiscal Systems and the Seigniorage
Problem

• Countries have different fiscal systems
• This leads countries to use different debt and
  monetary financing of the government budget
  deficit
• In a monetary union countries will be constrained
  in the way they finance their budget deficits

5
Theory of Optimal Public Finance

• Rational governments will use different sources
  of revenue so that the marginal cost of raising
  revenue through different means is equalized
• If the marginal cost of raising revenue by
  increasing taxes exceeds the marginal cost of
  raising revenues inflation (seigniorage) it
  will be optimal to reduce taxes and to increase
  inflation
• Countries will have different optimal inflation
  rates
• Generally countries with an underdeveloped tax
  system will find it more advantageous to raise
  revenues by inflation (seigniorage)

6
Different Fiscal Systems and the Seigniorage
Problem Main Point

• Less Developed Countries that join a monetary
  union with more developed countries that have a
  low rate of inflation will also have to lower
  inflation
• This means they will have to increase taxes
• Leads to a loss of welfare

Seigniorage Revenues (as of GDP) Seigniorage Revenues (as of GDP) Seigniorage Revenues (as of GDP) Seigniorage Revenues (as of GDP)
1976-85 1986-90 1993
Germany 0,2 0,6 0,5
Greece 3,4 1,5 0,7
Italy 2,6 0,7 0,5
Portugal 3,4 1,9 0,6
Spain 2,9 0,8 0,6
7
What About Symmetric Shocks?
Can France and Germany deal with this negative
shock in a monetary union?
8
Symmetric Shocks

• France and Germany can deal with a negative shock
  in a monetary union because monetary policy is
  centralized in the hands of the European Central
  Bank
• One interest rate for both countries due to ECB
• If ECB lowers the interest rate it stimulates
  aggregate demand
• ECB would be paralyzed in case of an asymmetric
  shock
• Ex if ECB reduces interest rates to stimulate
  demand in France it increases inflation in
  Germany
• If ECB increases interest rates to deal with
  German inflation it reduces demand in France

9
If France and Germany are NOT in a monetary union

• Is devaluation an attractive policy option for
  one of the countries facing a symmetric shock?
• NO!!
• Ex France devalues aggregate demand stimuated
  at the expense of Germany
• This shifts the German aggregate demand curve
  further to the left
• French export their problem to Germany
• Then Germany would react with tis own devaluation
  danger of a spiral of devaluations
• The two countries would have to coordinate their
  actions difficult for 2 independent states
• There is an advantage of a monetary union when
  faced with symmetric shocks (but not asymmetric
  shocks)

10
Critique of Optimum Currency Areas

• So far we have looked at why countries may find
  it costly to join a monetary union
• This analysis is known as The Theory of Optimum
  Currency Areas (OCA)
• Criticism of OCA
• The differences between countries may not be all
  that important
• The exchange rate mechanism may not be very
  effective in correcting for differences between
  nations
• The exchange rate may do more harm than good in
  the hands of politicians

11
I.1. The differences between countries

• There is no doubt that there are differences
  among countries
• Question Are these differences important enough
  to represent a stumbling block for monetary
  unification?
• Classical Mundell analysis
• Demand shift from one country to another
• Is this likely to occur frequently between the
  European countries that form a monetary union?
• Two views exist
• European Commission view
• Paul Krugman view

12
E.C. View

• Diferential shocks in demand will occur less in a
  monetary union
• Reason Trade between the industiral European
  nations is largely intra-industry trade based on
  economies of scale and imperfect competition
• Countries buy and sell to each other in the same
  category of products (ex. France sells cars to
  and buys cars from Germany)

13
E.C. View (cont.)

• This structure of trade leads to most demand
  shocks having similar effects in both countries
• Ex fewer demand for cars means fewer French and
  German cars get sold demand is affected
  similarly in both countries
• Removal of barriers in a single market will
  reinforce these tendencies
• Demand shocks will become symmetric as opposed to
  asymmetric

14
Paul Krugmans View

• Trade integration leads to regional concentration
  of industrial activities
• This leads to localization of industries
• Concentration of production to profit from
  economies of scale
• Trade integration leads to more concentration of
  regional activities

Regional Distribution of Auto Production, 1991 Regional Distribution of Auto Production, 1991 Regional Distribution of Auto Production, 1991 Regional Distribution of Auto Production, 1991
USA EU
Midwest 66,3 Germany 38,5
South 25,4 France 31,1
West 5,1 Italy 17,6
North-East 3,32 UK 12,9
15
Paul Krugmans View (cont.)

• When the EU becomes more integrated, it may
  become like the USA
• This suggests that sector-specific shocks may
  become country-specific shocks
• Countries faced with these shocks may then prefer
  to use the exchange rate as an economic policy to
  correct for disturbances

16
EC View and Krugman View Compared
Divergence Degree of divergent movments of
output and employment between groups of countries
(regions) which are candidates for a monetary
union Trade Integration Degree of trade
integration between these countries
17
E. C. View
As the degree of economic integration between
countries increases, asymmetric shocks will occur
less frequently (so that income and employment
will tend to diverge less between the countries
involved)
18
Paul Krugmans View
When economic integration increases the countries
involved become more specialized so that they
will be subjected to more rather than fewer
asymmetric shocks
19
EC vs. Krugman View

• There is a presumption in favor of the EC view
  because
• Even though economic integration can lead to
  concentration and its effects cannot be disputed
  however, as market integration between
  countries proceed national borders become less
  and less important
• Most likely clusters of economic activity will
  encompass borders
• Ex auto manufacturing in the region encompassing
  South Germany and North Italy in this case
  shocks in the auto industry will affect more than
  one country
• The argument is not that concentration will not
  happen but that national borders will become less
  relevant
• Regions may as a result experience asymmetric
  shocks regions may overlap existing borders
• Economic forces of integration are likely to
  decapacitate the exchange rate between national
  currencies as a force to deal with these shocks

20
EC vs. Krugman View

• Empirical analysis suggests that economic
  integration will make asymmetric shocks between
  nations less likely
• The rise of services economies of scale do not
  matter as much for services as for industrial
  activities
• Economic integration does not lead to regional
  concentration of services in the way it does with
  industries
• There is no regional integraiton in services and
  this sector counts for 70 or more of GDP in many
  EU countries

21
2. Effectiveness of the Exchange Rate Mechanism

• Not all asymmetric shocks will dissapear
• This is because nation-states still remain the
  main instruments of economic policies
• In the European Economic and Monetary Union
  monetary policies are centralized (due to the
  ECB) and therefore cease to be a source of
  asymmetric shocks
• Member countries however still ahve sovereignty
  in other economic areas
• Budgetary Field
• National Economic Institutions

22
Budgetary Field

• Most spending and taxing powers still vested in
  the hands of national authorities
• By changing taxes and spending a nation can
  create asymmetric shocks
• These shocks will be contained within the borders
  of that nation-state
• Ex. When a country raises taxes o wage income it
  only affects labor, spending and wage levels in
  that particular country
• These may lead to asymmetric shocks with other
  countries

23
National Economic Institutions

• Ex Wage bargaining systems
• Ex Legal Systems
• Ex Financial Systems

24

• Although economic integration is likely to weaken
  the occurrence of asymmetric shocks the existence
  of nation-states with their own peculiarities
  will be a continued source of asymmetric
  disturbances in a monetary union
• This has led some economists to argue that in
  order for a monetary union to function
  satisfactorily more political unification is
  necessary
• Monetary union should also put pressure on
  further political integration within member states

25
3. Institutional Differences in Labor Markets

• Will monetary integration change the behavior of
  labor unions? (so that differences may dissapear)
• National governments can still create employment
  in the government sector but now finance it by
  issuing debt
• Thus the effects of labor unions should not be
  completely disregarded
• Institutional differences in the national labor
  markets will continue to exist leading possibly
  to divergent wage and employment tendencies and
  severe adjustment problems when the exchange rate
  instrument is not available

26
4. Different Legal and Financial Systems

• Financial markets work differently across the EU
• Theres a risk that some monetary shocks will be
  transmitted differently
• Ex. Investors in high inflation coutnries like
  Italy do not tend to buy long term bonds in
  fact the long term bond market hardly exists
  government debt is mostly short-term it is
  exactly the opposite case in a low-inflation
  country like Germany

27
4. Different Legal and Financial Systems (cont.)
Maturity distribution of government bonds ( of total) Maturity distribution of government bonds ( of total) Maturity distribution of government bonds ( of total) Maturity distribution of government bonds ( of total)
Short-term (- 1 year) Medium and long term (1 year) Of which long term (5 years)
Italy 49,4 50,6 24,8
Germany 18,5 81,5 -
Netherlands 6,7 93,3 63,0
All this caused asymmetries in the way
EU-governments reacted to the same interest rate
changes in the past Ex. When the interest rate
changed, the Italian government budget was
immediately affected Italian debt has short
maturity, interest rates go up, Italian
government spends more on interest payments,
budget deficit increases These differences due to
inflation will dissapear in a monetary union
28
4. Different Legal and Financial Systems (cont.)

• Monetary union by itself will eliminate some of
  the institutional differences that exist between
  national financial systems however deeper
  differences like those that are the result of
  different legal systems will only dissapear by a
  convergence of national legal systems
• This means further political integration

29
5. Differences in Growth Rates

• Fast growing countries fast growing imports
• Depreciation of currency needed to allow exports
  to grow
• Monetary union makes this impossible
• This popular view has very little empirical
  support
• 1. Paul Krugmans reason against this view
• Economic growth is rarely like the scenario
  mentioned above
• it usually has to do with the development of new
  products
• there is higher income elasticity on their
  exports
• these countries can grow faster without incurring
  trade balance problems
• No depreciations needed

30
5. Differences in Growth Rates (cont.)

• 2. Existence of Capital Flows slow-growing
  countries will invest in the faster-growth
  country
• Fast-growing country can finance current account
  deficit without devaluing its currency
• In fact by joining a monetary union, a fast
  growing country may attract more foreign capital
  (since there is also no exchange rate
  uncertainty)
• Differences in the growth rates of countries
  cannot really be considered as an obstacle to
  monetary integration

31
II. Nominal and Real Depreciations of Currency

• By giving up ones national currency a country
  cannot change its exchange rate any more to
  correct for shocks in demand, costs or prices
• Question Are these exchange rates effective in
  making such corrections?
• Do nominal exchange rate changes permanently
  alter the real exchange rate of a country?
• If the answer is no different countries would
  not have extra costs when joining a monetary union

32
1. Devaluations to correct for asymmetric shocks

• In the previous story of France and Germany
  France devalues to cope with the problem

33
1. Devaluations to correct for asymmetric shocks
(cont.)

• Nominal exchange rate cahnges have only temporary
  effects on the competitiveness of coutnries.
  Over time the nominal devaluation leads to
  domestic cost and price increases which tend to
  restore the initial competitiveness
• Nominal devaluations only lead to temporary real
  devaluations
• Do countries not lose anything by relinquishing
  this instrument?
• NO!! They do lose something short-term effects
  in the absence of a devaluation

34
1. Devaluations to correct for asymmetric shocks
(cont.)

• In the long run the two policies (devaluation and
  expenditure reduction) lead to the same effect on
  output and the trade account
• In the long run the exchange rate will not solve
  problems that arise from differences between
  countries that originate in the goods markets.
  Manipulating money cannot change the real
  differences
• Their differences are in the short-term effects
• When a country devalues it avoids severe
  deflationary effects on domestic output during
  transition inflation increases
• In expenditure-reduction inflation is avoided
  however output decreases during the transition
  period

35
1. Devaluations to correct for asymmetric shocks
(cont.)

• Although a devaluation does not have a permanent
  effect on competitiveness and output its dynamics
  will be quite different from the dynamics
  engendered by the alternative policy which will
  necessarily have to be followed if the country
  has relinquished control over its national money
• This loss of a policy instrument will be a cost
  of the monetary union

36
2. Devaluations to correct for different policy
preferences

• The model of Italy and Germany and the Phillips
  Curve and the preferences of each one of these
  countries was a concern
• Both countries would have to accept unpopular
  points in the curve when joining a monetary union

37
2. Devaluations to correct for different policy
preferences

• This analysis depends on the assumption that the
  Phillips curve is stable which it is not
• Countries differ in terms of their preferences
  towards inflation and unemployment these
  differences are not a serious obstacle to joining
  a monetary union since countries cannot choose an
  optimal point on the Phillips curve

38
3. Productivity and inflation in a monetary union

• Upto now we have assumed that national inflation
  rates will be equalized in a monetary union
• THIS IS NOT TRUE!!
• There are regional differences even though they
  tend to be small they can be significant
• Ex. When Germany and Ireland are in a monetary
  union competition makes sure that the price
  changes of tradeable goods are equalized
• But this does not happen in non-tradeable goods
  (like electricity and water) because there is no
  international competition

39
CONCLUSION

• The traditional theory of OCAs tends to be
  rather pessimistic about the possibility for
  countries to join a monetary union at low cost
• The criticisms we have discussed are much less
  pessimistic
• The main reasons
• The ability of exchange rate changes to absorb
  asymmetric shocks is weaker than the traditional
  OCA theory has led us to believe
• Exchange rate changes usually have no permanent
  effects on output and employment

40
CONCLUSION (cont.)

• Countries that maintain independent monetary and
  exchange rate policies often find out that
  exchange rate movements can lead to macroeconomic
  disturbances instead of macroeconomic
  stabilization
• Exchange rates, contrary to popular belief,
  cannot be used frequently and costlessly

41
CONCLUSION (cont.)

• OCA theory though still has relevance because
• There are differences between countries that have
  political and institutional origins (ex. Labor
  markets, legal systems, governments, ...) which
  will continue to exist
• These can lead to adjustment problems in the
  future

42
CONCLUSION (cont.)

• The risks of high adjustment costs in the face of
  asymmetric disturbances can be reduced by
• Making markets more flexible (so that asymmetric
  shocks can be adjusted better)
• Speeding up the process of political unification
  (this will reduce the occurance of asymmetric
  disturbances that have a political or
  institutional origin)

43
Benefits of a Common Currency

• Costs have to do with macroeconomic management of
  the economy
• Benefits have to do with the microeconomic aspect
• Eliminating national currencies for a common
  currency leads to economic efficiency gains
• Elimination of transaction costs
• Elimination of exchange rate risk

44
Benefits of a Common Currency (cont.)

• Direct gains from the elimination of transaction
  costs
• Eliminating the costs of exchanging one currency
  into another is themost visible gain from a
  monetary union
• E.C. Estimates these gains between 13-20
  billion/year
• Of course banks will lose revenue they get for
  exchanging national currencies in a monetary union

45
Benefits of a Common Currency (cont.)

• Indirect gains from the elimination of
  transaction costs
• The scope for price discrimination between
  national markets will be reduced
• (TABLE HERE)
• The unification of currency along with the other
  measures in creating a single market will make
  price discrimination more difficult
• This is a benefit to the European consumer

46
Benefits of a Common Currency (cont.)

• Welfare gains from less uncertainty
• The uncertainty about future exchange rate
  cahnges introduces uncertainty about future firm
  revenues
• Welfare of firms will increase when common
  currency is introduced (exception firms that
  make money by taking on risk)