Common Currency Areas and European Monetary Union Copyright

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Common Currency Areas and European Monetary Union Copyright © 2010 Cengage Learning 11

Common Currency Areas and European Monetary Union Copyright © 2010 Cengage Learning 11

Common Currency and the European Monetary Union In the 1990 s, a number of

Common Currency and the European Monetary Union In the 1990 s, a number of European nations decided to give up their national currencies and use a new, common currency called the euro by joining European Economic and Monetary Union (EMU) Today’s lecture aims to answer the following questions: • Why did the countries decide to adopt euro? • What are the costs and advantages of that? • Is it optimal for Europe to have a single currency? Copyright © 2010 Cengage Learning

Common Currency Area • A common currency area is a geographical area throughout which

Common Currency Area • A common currency area is a geographical area throughout which a single currency circulates as the medium of exchange. • Another term for a common currency area is a currency union. • Closely related phenomenon is a monetary union that is a group of countries which have adopted permanently and irrevocably fixed exchange rates among the various currencies. Copyright © 2010 Cengage Learning

The Euro • The Maastricht Treaty of 1992 laid down: • various criteria for

The Euro • The Maastricht Treaty of 1992 laid down: • various criteria for eligibility to join the proposed currency union • the timetable for the introduction of the new single currency • and rules concerning the establishment of the European Central Bank (ECB). • The euro officially came into existence on 1 January 1999 and on 1 January 2002 the first euro notes and coins began to circulate. • Economic and monetary union (EMU) was seen as necessary to complete the single European market (SEM). • The Single European Act, passed by the European Parliament in 1986, identified 300 measures that would have to be addressed to complete the SEM. Copyright © 2010 Cengage Learning

The Euro • A series of European Directives was used to tell member state

The Euro • A series of European Directives was used to tell member state governments what they needed to do to achieve the following four goals: • free movement of goods, services, labour and capital between member states; • the approximation of relevant laws and administrative provisions between member states; • a common EU-wide competition policy; • and a system of common external tariffs. Copyright © 2010 Cengage Learning

The Benefits of a Single Currency • Elimination of Transaction Costs - the cost

The Benefits of a Single Currency • Elimination of Transaction Costs - the cost involved in converting currencies is a deadweight loss, so reducing these costs by adopting a single currency provides a clear gain to society. • Reduction in Price Discrimination - it is less likely that there will be price discrimination between countries because a single currency makes it more difficult to disguise price differences. • Reduction in Foreign Exchange Rate Variability - there will be no exchange rate fluctuations that create uncertainty for businesses engaging in trade between EMU countries. • Businesses could always deal with such uncertainty by engaging in forward foreign exchange contracts with their banks, but the banks charged for this service and a single currency eliminates this cost. • The absence of exchange rate fluctuations make business planning easier and may boost investment, with benefits for economic growth. Copyright © 2010 Cengage Learning

The Costs of a Single Currency • The major cost is that a country

The Costs of a Single Currency • The major cost is that a country joining a currency union gives up both its freedom to set its own monetary policy, and the possibility of macroeconomic adjustment through movements in the external value of its currency. • Suppose there is a shift in consumer preferences away from German goods and in favour of French goods. • The aggregate demand curve will shift to the left in Germany and to the right in France, leading to increased unemployment and downward pressure on prices in Germany, and lower unemployment and upward pressure on prices in France. Copyright © 2010 Cengage Learning

Figure 1 A Shift in Consumer Preferences Away from German Goods Towards French Goods

Figure 1 A Shift in Consumer Preferences Away from German Goods Towards French Goods Copyright© 2010 South-Western

The Costs of a Single Currency • If the governments do nothing then the

The Costs of a Single Currency • If the governments do nothing then the economies will, in the long run, return to their natural rates of unemployment. • If the two countries had retained separate currencies then the short-run fluctuations in aggregate demand would have been alleviated by a movement in the exchange rate. Copyright © 2010 Cengage Learning

Figure 2 A Shift in Consumer Preferences with Flexible Exchange Rates Copyright© 2010 South-Western

Figure 2 A Shift in Consumer Preferences with Flexible Exchange Rates Copyright© 2010 South-Western

The Costs of a Single Currency • Without this adjustment mechanism, German policy makers

The Costs of a Single Currency • Without this adjustment mechanism, German policy makers may wish to see a cut in interest rates to boost aggregate demand • French policy makers, however, will be more likely to favor a rise in the interest rate to contain inflation. • The ECB would be unable to satisfy both countries. Copyright © 2010 Cengage Learning

The Costs of a Single Currency • As discussed in lecture 5, the ECB

The Costs of a Single Currency • As discussed in lecture 5, the ECB pursues an inflation targeting strategy. • If a country’s inflation rate is below the Euroland average then monetary policy will be too tight for that country’s economic conditions. • If a country’s inflation rate is above average then monetary policy will be too loose for that country’s economic conditions. Copyright © 2010 Cengage Learning

CASE STUDY: The Exchange Rate Mechanism • Before the euro, most EU countries were

CASE STUDY: The Exchange Rate Mechanism • Before the euro, most EU countries were members of the European Exchange Rate Mechanism (ERM). • This was a semi-fixed or adjustable peg system that limited exchange rate fluctuations between member currencies. • In 1992 international speculators attacked the ERM, selling the UK pound and French franc heavily against the German mark. • The pound was withdrawn from the ERM as a result, and other adjustments had to be made. • Because international capital flows can be so huge, currency pegs like the ERM are always vulnerable to speculators. Copyright © 2010 Cengage Learning

Optimum Currency Areas • An optimum currency area is a group of countries for

Optimum Currency Areas • An optimum currency area is a group of countries for which it is optimal to adopt a common currency and form a currency union. • OCA theory attempts to specify criteria for the optimality of a currency union for a given group of countries. • The qualifier ‘optimal’ is used loosely and should be taken to refer to the ability of the countries concerned to limit the costs of monetary union and enhance the benefits. Copyright © 2010 Cengage Learning

OCAs: Characteristics That Reduce the Costs of a Single Currency • A high degree

OCAs: Characteristics That Reduce the Costs of a Single Currency • A high degree of real wage flexibility so that wages respond strongly to fluctuations in unemployment will ensure that long-run equilibrium will be restored quickly following any macroeconomic disturbance. • A high degree of labor mobility between the member countries of a currency union will also ensure macroeconomic stability. • In the earlier example, the migration of labour from Germany to France would alleviate inflationary pressure in France and keep down unemployment in Germany. Copyright © 2010 Cengage Learning

OCAs: Characteristics That Reduce the Costs of a Single Currency • A high degree

OCAs: Characteristics That Reduce the Costs of a Single Currency • A high degree of capital mobility can also help alleviate the problems of asymmetric shocks. • Residents of a country experiencing recession may borrow money from residents of a country experiencing a boom to make up for their temporary fall in income. • A high degree of trade integration among a group of countries will lead to greater benefits should those countries establish a currency union. Copyright © 2010 Cengage Learning

CASE STUDY: The Roman Empire • The first European monetary union was the Roman

CASE STUDY: The Roman Empire • The first European monetary union was the Roman Empire. Throughout a geographical area larger than today’s EU, Roman coins came to be the predominant medium of exchange. • The widespread use of Roman money was due in part to the presence of Roman occupying forces, but also to the increased amount of international trade across the empire. • Rome did not decree its money must be the single currency. Copyright © 2010 Cengage Learning

CASE STUDY: The Roman Empire • This common currency area broke down around the

CASE STUDY: The Roman Empire • This common currency area broke down around the end of 5 th century AD. • The single most important reason for the breakdown was almost certainly the loss of financial and political control by the Romans. • Rising political instability made trade more risky and difficult so that international trade integration fell. Copyright © 2010 Cengage Learning

Is Europe an Optimum Currency Area? • We can think of the ratio of

Is Europe an Optimum Currency Area? • We can think of the ratio of the sum of intra-EU exports and imports to GDP as a measure of trade integration. • Though variable, the degree of trade integration is quite high on average. • It has also been increasing over time. • The rate of increase appears to have been greater since the currency union was established, suggesting that the extent of trade integration may actually be endogenous. • The figures in Table 1 suggest that there are probably significant gains from EMU. Copyright © 2010 Cengage Learning

Table 1 Imports Plus Exports of 15 EU Countries From and To Other EU

Table 1 Imports Plus Exports of 15 EU Countries From and To Other EU Countries as a % of GDP Copyright© 2010 South-Western

Is Europe an Optimum Currency Area? • Research suggests that continental European labour markets

Is Europe an Optimum Currency Area? • Research suggests that continental European labour markets are among the most rigid in the world, while the UK is now one of the most flexible. • One reason is the high degree of collective bargaining that is common in continental Europe. • The introduction of the euro may have had a negative effect on European wage flexibility. • Many collective wage agreements cover a firm’s workers in a number of EU countries and a single currency brings transparency to wage differentials between the firm’s workers in different countries. • In these circumstances it will be difficult for a firm to avoid raising wages in Germany, say, when the firm is obliged to raise wages in France because the labor market is tight, even though there is unemployment in Germany. Copyright © 2010 Cengage Learning

Is Europe an Optimum Currency Area? • The costs to a firm of reducing

Is Europe an Optimum Currency Area? • The costs to a firm of reducing or increasing its workforce are generally much higher in continental Europe than is the case in the USA or the UK. • On the whole, adjustment to asymmetric shocks through real wage changes is unlikely to be significant in the euro area. • Labour is notoriously immobile across the 12 euro area countries. • In fact, even within individual euro area countries labour mobility is much lower than is the case in the USA. • Euroland scores very low on this OCA criterion. Copyright © 2010 Cengage Learning

Is Europe an Optimum Currency Area? • Prior to the introduction of the euro,

Is Europe an Optimum Currency Area? • Prior to the introduction of the euro, financial integration among Euroland countries was probably quite low. • Since the introduction of the euro the integration of wholesale financial markets has increased dramatically. • There is a liquid euro money market with single interbank interest market rates. Copyright © 2010 Cengage Learning

Is Europe an Optimum Currency Area? • In the government bond market the yields

Is Europe an Optimum Currency Area? • In the government bond market the yields on the bonds of different Euroland governments are similar and tend to move very closely together, illustrating the high degree of integration in this market too. • Integration of retail financial markets is much less. There is limited cross-border retail banking activity and there are persistent differences in bank lending rates in different countries. Copyright © 2010 Cengage Learning

Figure 3 Growth Rates in Germany, France and the Whole Euro Area Copyright© 2010

Figure 3 Growth Rates in Germany, France and the Whole Euro Area Copyright© 2010 South-Western

Is Europe an Optimum Currency Area? • The economic cycle across the euro area

Is Europe an Optimum Currency Area? • The economic cycle across the euro area countries appears to be positively correlated – the timing of booms and recession seems to be very close. • There is no clear evidence of asymmetric shocks affecting these countries. • However, a problem remains in that some countries may have a persistently higher rate of growth than others. • Ireland over the period 1994 -2002 provides an example. Copyright © 2010 Cengage Learning

Figure 4 Growth Rates in Ireland the Whole Euro Area Copyright© 2010 South-Western

Figure 4 Growth Rates in Ireland the Whole Euro Area Copyright© 2010 South-Western

Is Europe an Optimum Currency Area? • There is no clear-cut answer to the

Is Europe an Optimum Currency Area? • There is no clear-cut answer to the question. • Perhaps the only true test of whether Euroland is an OCA is to see whether it survives in the long run. Copyright © 2010 Cengage Learning

Fiscal Policy and Common Currency Areas • Fiscal federalism is a fiscal system for

Fiscal Policy and Common Currency Areas • Fiscal federalism is a fiscal system for a group of countries involving a common fiscal budget and system of fiscal transfers across countries. • If a currency union had a common fiscal policy then fiscal policy in the currency union would work much as fiscal policy in a single national economy works. • The problem might be that taxpayers in one country may not be happy to see their taxes spent on transfers to residents of another country. Copyright © 2010 Cengage Learning

Fiscal Policy and Common Currency Areas • In the absence of fiscal federalism there

Fiscal Policy and Common Currency Areas • In the absence of fiscal federalism there is a potential free rider problem. • Whenever a government raises it levels of debt to very high levels there is a possibility that the government may default on the debt. • Generally the financial markets will charge higher rates of interest to lend to a government that runs up large debts. • Inside a currency union, it might be expected that the other members of the union will bail out a government that has borrowed heavily, rather than see it default. • If the financial market takes this view, then the interest rate penalty imposed on the high borrowing government will be less. Copyright © 2010 Cengage Learning

Fiscal Policy and Common Currency Areas • Because all the other governments are regarded

Fiscal Policy and Common Currency Areas • Because all the other governments are regarded as underwriters of the high borrowing government’s debt, they will all face higher interest rates on their borrowing than they otherwise would. • Thus, the high borrowing government borrows more cheaply than it could outside of the currency union, and imposes costs on the other currency union members. • Currency union members can enter into ‘no bail-out’ agreements, but there is an issue about the credibility of such agreements. • So a set of fiscal rules may be used instead. At the outset of EMU, just such a set of rules was drawn up, known as the Stability and Growth Pact (SGP). Copyright © 2010 Cengage Learning

Fiscal Policy and Common Currency Areas • The main components of the SGP were:

Fiscal Policy and Common Currency Areas • The main components of the SGP were: • Members should aim to achieve balanced budgets. • Members with a budget deficit of more than 3 per cent of GDP would be subject to fines of up to 0. 5 per cent of GDP unless the country was experiencing exceptional circumstances or a recession in which GDP declined by 2 per cent or more in a single year. • The choice of a maximum budget deficit of 3 per cent of GDP was related to the clause in the Maastricht Treaty that suggested the debt-to-GDP ratio should be no more than 60 per cent. Copyright © 2010 Cengage Learning

Fiscal Policy and Common Currency Areas • While there is some logic to this,

Fiscal Policy and Common Currency Areas • While there is some logic to this, it is not clear why the SGP suggested that members should aim for balanced budget. • The crucial question was whether the maximum allowable budget deficit would be enough to allow the automatic stabilizers come into play when an economy enters a recession. • The early years of EMU were years of sluggish GDP growth and several countries found themselves with budget deficits in excess of the SGP limit, including both France and Germany. • These countries then managed to persuade other EMU members not to impose fines, and in 2004 the European Commission drew up guidelines for softening the SGP. Copyright © 2010 Cengage Learning

Fiscal Policy and Common Currency Areas • Having a system of rigid rules and

Fiscal Policy and Common Currency Areas • Having a system of rigid rules and fines, but no credible way of enforcing the sanctions, was not the correct way to ensure fiscal stability in the euro area. • Now the system effectively relies on peer pressure and concern for national prestige – no country wants to be seen as profligate and irresponsible. Copyright © 2010 Cengage Learning

Summary • A common currency area (a. k. a. currency union or monetary union)

Summary • A common currency area (a. k. a. currency union or monetary union) is a geographical area through which one currency circulates and is accepted as the medium of exchange. • The formation of a common currency area can bring significant benefits to the members of the currency union, particularly if there is already a high degree of international trade among them (i. e. a high level of trade integration). • This is primarily because of the reductions in transaction costs in trade and the reduction in exchange rate uncertainty. Copyright © 2010 Cengage Learning

Summary • There are, however, costs of joining a currency union, namely: • the

Summary • There are, however, costs of joining a currency union, namely: • the loss of independent monetary policy • and the loss of the exchange rate as a means of macroeconomic adjustment. • These adjustment costs will be lower the greater is the degree of real wage flexibility, labour mobility and capital market integration across the currency union, and also the less the members of the currency union suffer from asymmetric demand shocks. Copyright © 2010 Cengage Learning

Summary • A group of countries that has a high level of trade integration,

Summary • A group of countries that has a high level of trade integration, high labour mobility and real wage flexibility, a high level of capital market integration and whose member countries do not suffer from asymmetric shocks, is termed an optimum currency area (OCA). • An OCA is most likely to benefit from currency union. • It is possible that a group of countries may become an OCA after becoming a currency union, as having a common currency may further enhance trade integration, thereby helping to synchronize members’ economic cycles, and having a single currency may also help to foster increased labour mobility and capital market integration. Copyright © 2010 Cengage Learning

Summary • The current euro area displays, overall, a high degree of trade integration

Summary • The current euro area displays, overall, a high degree of trade integration and does not appear to be plagued by asymmetric demand shocks, but real wage flexibility and labour mobility both appear to be low. • Although the introduction of the euro has led to a high degree of Euroland financial market integration at the wholesale level, retail financial markets remain nationally segregated. • Overall, the euro area is probably not at present an optimum currency area, although it may eventually become one. Copyright © 2010 Cengage Learning

Summary • The problems of adjustment within a currency union that is not an

Summary • The problems of adjustment within a currency union that is not an OCA may be alleviated by fiscal federalism – a common fiscal budget and a system of taxes and fiscal transfers across member countries. • In practice, however, fiscal federalism may be difficult to implement for political reasons. • Having separate national fiscal policies in the countries making up a currency union may give rise to a free rider problem. • It is for this reason that a currency union may wish to impose rules on the national fiscal policies of its members. Copyright © 2010 Cengage Learning