Jaromr indel

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Optimal Currency Area
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Jaromír indel
• ECES

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Topics
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Optimal Currency Area
• Theory, indices, ...
• Euro-area OCA?
• Italian case,
• CEE countries and EU OCA?
• Are CEE countries OCA with Euro-area?

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Exchange rate regime classification
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Floating rate regimes
• Floating rate with inflation targeting
• Managed exchange rates without explicit targets
  (dirty float)
• Pure floating rates No CB intervention
• Fixed-rate regimes
• Soft pegs Explicit targets without full monetary
  adjustment
• Exchange rate bands and target zones
• Crawling pegs, corridors, and tabilias
• Use of sterilized intervention
• Hard pegs Full use of automatic monetary
  adjustment
• Currency unions
• Dollarization
• Currency boards

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Exchange rate regime classification
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Source Holub, T. Foreign Exchange Interventions
Under Inflation Targeting The Czech Experience.
CNB (2004).
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Review of the OCA theory
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Friedman (1953) - view on floating ER
• Mundell (1961) - his model of an asymmetric
  shift in demand of two countries stressed that
  optimum currency area can differ form the actual
  currency area and offered some non-exchange rates
  means for adjustment as labour mobility, nominal
  flexibility and fiscal transfers
• McKinnon (1963), Kenen (1969), Ingram (In
  Kawai, 1987) extended the list of non-exchange
  rates means for adjustment (financial
  integration, openness and national product
  diversification)
• McKinnon (2000) - presents a neo-Keynesian
  model (elimination of the effect of shocks by
  national monetary and fiscal policies downward
  sloping and stable Phillips curve)
• Mundell (1973a, 1973b) - which bring completely
  different argumentation concerning the optimum
  currency area
• others Frankel and Rose (1998 a, b), Krugman
  (1993), De Grauwe (1997), Rodrick (2000), Fidrmuc
  (2001), etc.

Source Komárek
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Currency unions
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Source Komárek
7
Currency unions
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Source Komárek
8
Currency unions
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Source Komárek
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Review of the OCA theory
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Advantages of currency union
• Lower transaction costs reducing ER uncertainty
• lower ER risk (FRA is expensive within high
  volatil currency expensive for small producers)
• Transparency of prices higher competition
• Higher gains to trade Rose (increase in foreign
  trade)
• for example risk-averse producers involve in
  foreign trade
• Nominal archor for higher inflation coutries
  lower inflation as result
• Disadvantages
• Loss of independent monetary policy (compare with
  dichotomy of MP)
• Decreased flexibility in reacting to external
  shocks

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Review of the OCA theory
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Benefits outweigh costs if
• Markets are highly integrated
• Goods markets, Financial markets, Labor markets
• Shocks to currency union members are symmetrical
  (UK - oil)
• Labor markets are flexible
• Flexible fiscal policy for fiscal transfers (to
  cope with shocks)
• Question of OCA endogenity
• Convergence to OCA and higher flexibility follow
  integration process

Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Review of the OCA theory
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Symmetry of shocks and Integration
Try to draw in the possible currency union
between the USA and Canada.
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Review of the OCA theory
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Specialization vs. intra-industry trade
Frankel and Rose (1997) - Integration increases
intra-industry trade what caused business cycle
convergence
Krugman (1993) - Economies of scale integration
increases trade specialization what caused
asymmetric shocks
Source Komárek (CNB).
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Common Currency interest group forming
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
The possible preferences of economic sectors to
national monetary policy
Source Frieden, J. (1991), p. 445
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Maastricht convergence criteria and OCA theory
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Ignored OCA theorys micro factors
• Emphasized macro factors
• Desire to ensure same cyclical position
• inflation not only factor
• Low inflation countries wanted guarantee of
  fiscal restraint (compare with nowdays situation
  in Germany)

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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Increase of foreign savings for financing Italian
economy
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• What about OCA?
• Integration, flexibility, symmetry of shocks,
  fiscal flexibility
• Italy and Euro-area OCA?
• Integration
• About 60 of Italys trade is with EU partners
  Comparisions - France63 and Belgium73
• Much better integrated than Argentina vs. US
• Some barriers to financial market integration,
  e.g., banking
• Labor mobility is low

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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
and high fiscal indebtedness
but debt will growth D deficit/(qp)
yield from integration. Without integration, no
cheap indebtedness.
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Labor mobility is low and high ridigity at labor
  market

very low flexibility in the world comparison
dangerous high union coverage (in addition
political active) and low employerscoordination
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Euro-area OCA? Italian case
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Why flexibility? Shocks? Asymmetry? ???

very low flexibility at labor market bring
longer recovery to structural shock low
correlation within real demand shock
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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Italy and leaving EURO solution?
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• YES
• RER and competitiveness it can also enhanced
  fiscal consolodition which brings easier
  monetary policy
• Yes, it will bring quick recovery
• NO it is more realistic
• High indebtedness (increase interest rate for
  Italian debt risk premia expected devaulation
  of new lira)
• Politicians are weak x Unions strong (strikes)
  no fiscal consolidation, no labor market reforms
• Higher inflation environment to reduce debt

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Message from Italy for CEE countries
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague

• Labor market Finish reforms before entry
• Fiscal policy
• Long-term fiscal sustainability should be
  achieved for fiscal flexibility
• One-off measures to meet entry conditions is not
  enough
• Exchange rate Entry rate should be fundamental
  or realistic (adjustment of RER after entry is
  difficult)
• NER (common NER), ULC (labor market and
  productivity), price differentials (compare with
  price convergence)

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CEE countries and EA OCA?
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
GDP development (year on year changes)
Source CNB, 2005.
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CEE countries and EA OCA?
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Correlation of economic activity (1 y/y, 2- q/q,
3 HP filter)
Source CNB, 2005.
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CEE countries and EA OCA?
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Shock symmetry with euro-area
Source Prof. E. Dolan, Lecture at VSE Prague,
2005.
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CEE countries and EA OCA?
The Puzzles of Central and Eastern Europe
Transformation and Integration
ECES, Prague
Structural similarity (lower higher similarity)
Source CNB, 2005.