Chapter 2

The Theory of Optimum Currency Areas: A Critique

Critique of OCA-theory can be formulated at three different levels: How relevant are the differences

between countries? Should we worry? Is national monetary policy (including

exchange rate policy) effective? How credible are national monetary

policies?

How relevant are the differences between countries?

Should we worry?Let’s analyze these differences

1. How likely are asymmetric demand shocks when integration increases?There exist two views

Optimistic view: • intra-industry trade leads to similar

specialization patterns• Integration leads to more equal economic

structures and less asymmetric shocks Pessimistic view:

• economies of scale lead to agglomeration effects and clustering

• Integration leads to more asymmetric shocks

Figure 2.1 Optimistic viewdivergence

Trade integration

Figure 2.2 Pessimistic viewdivergence

Trade integration

Which view is likely to prevail? A little bit of both But even if pessimistic view prevails,

agglomeration effect will be blind to national borders

Then asymmetric shocks cannot be dealt with by national monetary policies

Empirical evidence of Frankel and Rose favours optimistic view.

Role of services: they are increasingly important, and less subject to economies of scale

2. Asymmetric shocks and the nation-state

Existence of nation-states is a source of asymmetric shocks Taxation and spending remains in

realm of national soveignty Social policies are national Wage policies

This creates a need for further political integration in a monetary union

Additional explanations: Beggar-Thy-Neighbour in the Eurozone

Nominal wage increases (in %)

0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004 2005 2006

perc

ent i

ncre

ase

Germany

Eurozone

US

UK

Wage policies in Germany

Since 2000 declining nominal growth of wages in Germany

Induced by the need to restore previous losses of competitiveness

And a desire to face competition from low wage countries

Germany improved its competitive position vis a vis the rest of the Eurozone

Note also contrast with US and UK

Dramatic effect on competitive positions within the Eurozone

Real effective exchange rates (ULC) within Eurozone

80

85

90

95

100

105

110

115

120

1998 1999 2000 2001 2002 2003 2004 2005

ULC

BLEUDenmarkGermanyGreeceSpainFranceIrelandItalyNetherlAustriaPortugalFinland

Index is based on ULC (takes into account productivity differentials)

Germany improves its competitive position

At the expense of many other Eurozone countries

3. Institutional differences in the labour market

Institutional differences in labour markets create asymmetries in the transmission of shocks

Some of these differences disappear in the monetary union Monetary union puts pressure on trade

unions Other differences will remain in

place

4. Different legal systems and financial markets

The reduction of inflation differentials in monetary union leads to institutional convergence e.g. maturity structure in bond markets

converges However, not all institutional differences

will disappear Legal systems remain very different

creating ‘deep’ differences in financial systems Cfr. Difference between Anglo-Saxon and

Continental European financing of firms

Is national monetary policy effective?

Nominal and real depreciations of currencies The question we analyse here is

whether national monetary policies are effective instruments to correct for asymmetric disturbances.

Two disturbances are analyzed Permanent asymmetric demand shock Temporary asymmetric demand shock

Permanent asymmetric demand shocks

These were analysed in the previous chapter

These require a change in relative prices

Such a relative price change cannot be achieved by monetary policies

Figure 2.5 Prices and cost effects of a national monetary policy

PF

YF

DF

D’F

SF(W1)

S’F(W2)

F

F’

After monetary expansion real wage declinesWorkers will want to be compensated by higher nominal wageSupply shifts upwards thereby reducing output effect of monetary expansionEffectiveness of monetaey policy is reducedIt does not make a difference whether country is in MU

However Monetary expansion can, however,

sometimes make the dynamics towards new equilibrium less costly than alternative policy strategies.

The latter is typically more deflationary and leads to larger output losses

Adjustment through deflation

Adjustment through monetary expansion

National monetary policies to stabilize for temporary asymmetric demand shocks

Many demand shocks are temporary. For example, business cycle shocks.

These business cycle shocks can be asymmetric the issue that arises here is one of

macroeconomic stabilization. Let us return to figure 1.1 of the previous chapter.

PF PG

YF YG

France Germany

Figure 1.1 Aggregate demand and supply in France and Germany

DFDG

SFSG

We now interpret this figure as representing completely asynchronous business cycle shocks, i.e. when there is a recession in France there is a boom in

Germany. In the next period, it will then be the other way around with a boom in France and a recession in Germany.

If these two countries form a monetary union they have a problem: The common central bank is paralysed: if it lowers the interest rate to alleviate the French

problem, it will increase inflationary pressures in Germany; if it raises the interest rate to counter the inflationary

pressures in Germany it will intensify the recession in France.

since the shocks are temporary wage flexibility and mobility of labour cannot be invoked to solve this problem.

in a monetary union there is simply no solution to this problem: the common central bank cannot stabilize output at the country level; it can only do this at the union level.

When France and Germany, however, keep their own money they have the tools to stabilize output at the national level. Thus when France is hit be a recession the

French central bank can stimulate aggregate demand by reducing the interest rate and allowing the French Franc to depreciate.

Similarly, when Germany experiences a boom, its central bank can raise the interest rate and allow the currency to appreciate to dampen the boom.

In a monetary union these countries loose their ability to do so.

The question that arises here is how effective these stabilization policies are at the national level.

We postpone the discussion here, and we will return to it later.

There we will show that sometimes too active a use of monetary stabilization can lead to new sources of instability.

An aside: Productivity and inflation in monetary union

The Balassa-Samuelson effect Inflation differentials in monetary union can be

significantAverage yearly inflation in Eurozone countries, 1999-2003 (%)

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

D A F B FIN Euro LUX I NL E EL P IRL

Infla

tion

Balassa-Samuelson model Inflation in France Inflation in Ireland

(we assume that inflation in non-tradables is equal to wage inflation)

Inflation rates in tradable goods sectors are equal This leads to Assuming that differences in wage increases reflect

differences in productivity growth we obtain

Inflation in Ireland exceeds inflation in France if Irish productivity increases faster than French productivity

FFF wpcp...

)1(

III wpcp...

)1(

IF pp..

))(1(....IFIF wwpccp

))(1(....IFIF qqpccp

should wage bargaining be centralized in monetary union?

IFIF qqww

•This implies that if productivity growth is higher in Ireland than in France, wages should increase faster in Ireland than in France•If centralized wage bargaining leads to equal wage increases, France looses competitiveness

How credible are national monetary policies?

Devaluation, time consistency, and credibility

Credibility affects the effectiveness of policies

We use Barro-Gordon model We first develop closed-economy

version Then we develop two-country

version

Barro-Gordon modelFigure 2.9 The Phillips curve and natural unemployment .p

2.p

1.p

.2

.ppe

.1

.ppe

NU U

0.

ep

•There is a short-term tradeoff between inflation and unemployment for every level of expected inflation•The vertical line represents the 'long-term' vertical Phillips curve. It is the collection of all points for which •This vertical line defines the natural rate of unemployment UN

.. epp

U

I3

I2

I1

Figure 2.10 The preferences of the authorities

p•Indifference curves are concave

•Slope expresses relative importance attached to fighting inflation versus fighting unemployment

p

U

I3

I2

I1

Figure 2.11 The preferences of the authorities

U

‘Hard-nosed’ government ‘Wet’ government

I1

I2

I3

p

•‘Hard-nosed’ government attaches a lot of weight to fighting inflation

•‘Wet’ government attaches a lot of weight to fighting unemployment

Figure 2.12 The equilibrium inflation rate

p

U

1p

UN

1ppe

0ep

B

C

E

A

•Announcing a zero inflation policy is not credible because authorities prefer point B to A

•Rational agents know this

•Therefore they will set their expectations about inflation such that authorities have no incentive anymore from the announced inflation rate

•This is achieved in point E, which id the rational expectations time consistent equilibrium

p

U

Figure 2.13 Equilibrium with ‘hard-nosed’ and ‘wet’ governments

U

‘Hard-nosed’ government ‘Wet’ government

p

UN UN

AB

E

A

B

E

•‘Hard-nosed’ government achieves lower inflation equilibrium than ‘wet’ government without imposing more unemployment in the long run

The Barro-Gordon model in an open economy

We add the purchasing power parity condition to link the inflation rates of two countries, called Germany and Italy, i.e.

GI ppe

UG

How can Italy reach a more attractive (lower) inflation equilibrium?

UI

Germany Italy

Ip

A

E

C

G

FGp

Gp

Fixing the exchange rate of the lira with the mark is not credible, because Italian authorities have an incentive to create surprise inflation (devaluation)

Only by abolishing the Italian central bank and adopting mark can Italy escape from high inflation equilibrium

This is also what countries that decide to “dollarize” hope to achieve

Monetary union is more complicated because in monetary union both central banks decide jointly and a new currency is created

This leads to problem in that new central bank may not have the same reputation as the German Bundesbank.

The latter is reluctant to join

Optimal stabilisation and monetary union

A

B

C

B’

U

UU

UN U1 U2

π1

UL

•Dotted line is optimal stablisation line•Without stabilisation unemployment would increase to B’ after shock•With stabilisation increase in unemployment is limited to B•The price paid is higher inflation •Price increases with steepness of stabilisation line

A

B

CB’

U

UU

UN U1 U2

π2

•This country cares less about unemployment•Same shock will lead to stronger increase in unemployment•But less inflation

when countries join a monetary union, they indeed loose an instrument of policy that allows them to better absorb temporary (asymmetric) shocks.

However, this loss may not always be perceived to be very costly because countries that actively use such stabilization policies also pay a price in terms of higher long-term rate of inflation.

Cost of monetary union and openness

PO PC

YOYC

DO

SO

DC

SC

Figure 2.16 Effectiveness of devaluation as a function of openness

Very open country Relatively closed country

Figure 2.17 The cost of a monetary union and the openness of a country

Cost(% of GDP)

Trade (% of GDP

•Countries that are very open experience less costs of joining a monetary union compared to relatively closed economies

•The reason is that relatively open economies loose an instument of policy that is relatively ineffective