economics of european integration - stephen...
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Economics of European IntegrationLecture 4
Stephen Kinsella
University of [email protected]
September 29, 2009
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 1 / 21
Today
1 Economic and Monetary Union
2 Optimum Currency Area Theory
3 Costs and Benefits of EMU
4 Ancient Rome: This too shall pass
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 2 / 21
Learning Outcomes
1 Analyse effects of preferential liberalisation using MS/MD apparatus.
2 Describe optimal currency area theory and criteria
3 Understand EMU, and its costs and benefits.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 3 / 21
Learning Outcomes
1 Analyse effects of preferential liberalisation using MS/MD apparatus.
2 Describe optimal currency area theory and criteria
3 Understand EMU, and its costs and benefits.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 3 / 21
Part One of Four. Preferential Liberalisation
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 4 / 21
Preferential Liberalisation: MS-MD Equilibrium
Domestic price
Home
imports
MD
PFT
RoW
Exports
Partner
Exports
XSP XSR MS
M=XP+XR
Partner Home RoW
Border price
2 1
XP X
R
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 5 / 21
Preferential Liberalisation
Consider Home removes T on imports only from Partner
1st step is to construct the new MS curve The liberalisation shifts up
MS (as with MFN liberalisation) but not as far since only on half of
imports
Shifts up MS to half way between MS (free trade) and MS (MFN T ),
but more complex, kinked MS curve with PTA.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 6 / 21
Preferential Liberalisation
Consider Home removes T on imports only from Partner
1st step is to construct the new MS curve The liberalisation shifts up
MS (as with MFN liberalisation) but not as far since only on half of
imports
Shifts up MS to half way between MS (free trade) and MS (MFN T ),
but more complex, kinked MS curve with PTA.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 6 / 21
Comparative Statics
Domestic price
Home
imports
MD
PFT
RoW
Exports
Partner
Exports
XSP XSR MS
MSMFN
P’
M’ M=XP+XR
Partner Home RoW
Border price Border price
T
P’-T
2 1
X’R X’
P
XP X
R
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 7 / 21
What happens to domestic prices?
domestic price falls to P � from P ��
Partner-based firms see border price rise, P � − T to P ��
RoW firms see border price fall from P � − T to P �� − T .
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 8 / 21
What happens to domestic prices?
domestic price falls to P � from P ��
Partner-based firms see border price rise, P � − T to P ��
RoW firms see border price fall from P � − T to P �� − T .
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 8 / 21
Home/Border Effects
Domestic price
MD
XSP XSR
MS
MSMFN
M’
Border price Border price
MSPTA
P’
T
P”
P’-T
P”-T
XR” XR’ XP’ XP” M”
P’-T
P”
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 9 / 21
Welfare Effects of Customs Union Formation1 In market for good 1, Home change = A + B − C1− C22 In market for good 2, Home change = +D1 + D2, and (D1 = C1)3 Net Home impact = A + B − C24 Partner impact identical. RoW loses big time.
euros
imports
MD
euros
Exports
XS
M’
A
D 2
D 1 C 1
B
C2
XP” XP’ XR” XP’
P’-T
P”
P’
P”-T
Welfare Effects of Customs Union Formation1 In market for good 1, Home change = A + B − C1− C22 In market for good 2, Home change = +D1 + D2, and (D1 = C1)3 Net Home impact = A + B − C24 Partner impact identical. RoW loses big time.
euros
imports
MD
euros
Exports
XS
M’
A
D 2
D 1 C 1
B
C2
XP” XP’ XR” XP’
P’-T
P”
P’
P”-T
Welfare Effects of Customs Union Formation1 In market for good 1, Home change = A + B − C1− C22 In market for good 2, Home change = +D1 + D2, and (D1 = C1)3 Net Home impact = A + B − C24 Partner impact identical. RoW loses big time.
euros
imports
MD
euros
Exports
XS
M’
A
D 2
D 1 C 1
B
C2
XP” XP’ XR” XP’
P’-T
P”
P’
P”-T
CU vs FTA
FTA like CU but no Common External Tariff
Opens door to ‘tariff cheats’, goods from RoW destined for Homemarket enter via Partner if Partner has lower external tariff, called‘trade deflection’
Solution is ‘rules of origin’ meant to establish where a good was made.
Problems: Difficult and expensive to administer, especially as worldget more integrated
Rules often become vehicle for disguised protection.
Despite the origin-problem in FTAs, almost all preferential tradearrangements in world are FTAs.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 11 / 21
CU vs FTA
FTA like CU but no Common External Tariff
Opens door to ‘tariff cheats’, goods from RoW destined for Homemarket enter via Partner if Partner has lower external tariff, called‘trade deflection’
Solution is ‘rules of origin’ meant to establish where a good was made.
Problems: Difficult and expensive to administer, especially as worldget more integrated
Rules often become vehicle for disguised protection.
Despite the origin-problem in FTAs, almost all preferential tradearrangements in world are FTAs.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 11 / 21
CU vs FTA
FTA like CU but no Common External Tariff
Opens door to ‘tariff cheats’, goods from RoW destined for Homemarket enter via Partner if Partner has lower external tariff, called‘trade deflection’
Solution is ‘rules of origin’ meant to establish where a good was made.
Problems: Difficult and expensive to administer, especially as worldget more integrated
Rules often become vehicle for disguised protection.
Despite the origin-problem in FTAs, almost all preferential tradearrangements in world are FTAs.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 11 / 21
CU vs FTA
FTA like CU but no Common External Tariff
Opens door to ‘tariff cheats’, goods from RoW destined for Homemarket enter via Partner if Partner has lower external tariff, called‘trade deflection’
Solution is ‘rules of origin’ meant to establish where a good was made.
Problems: Difficult and expensive to administer, especially as worldget more integrated
Rules often become vehicle for disguised protection.
Despite the origin-problem in FTAs, almost all preferential tradearrangements in world are FTAs.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 11 / 21
CU vs FTA
FTA like CU but no Common External Tariff
Opens door to ‘tariff cheats’, goods from RoW destined for Homemarket enter via Partner if Partner has lower external tariff, called‘trade deflection’
Solution is ‘rules of origin’ meant to establish where a good was made.
Problems: Difficult and expensive to administer, especially as worldget more integrated
Rules often become vehicle for disguised protection.
Despite the origin-problem in FTAs, almost all preferential tradearrangements in world are FTAs.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 11 / 21
Part Two of Four. Optimal Currency Areas
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 12 / 21
OCA Theory
Mundell (1961), Kenen (1969), Tavlas.
See Francesco Mongelli ECB Article.
Basic Idea: when it is a good idea for 2 or more countries to share acurrency?
Definition (Optimum Currency Area)
[T]he optimal geographic domain of a single currency, or of severalcurrencies, whose exchange rates are irrevocably pegged and might beunified. The single currency, or the pegged currencies, can fluctuate onlyin unison against the rest of the world.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 13 / 21
A region is optimal as an OCA to the extent it exhibits:
Labour & factor mobility
Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.
Production diversification
Openness
Fiscal transfers & fiscal integration
Homogeneous preferences
Commonality of destiny & political integration
OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 14 / 21
A region is optimal as an OCA to the extent it exhibits:
Labour & factor mobility
Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.
Production diversification
Openness
Fiscal transfers & fiscal integration
Homogeneous preferences
Commonality of destiny & political integration
OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 14 / 21
A region is optimal as an OCA to the extent it exhibits:
Labour & factor mobility
Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.
Production diversification
Openness
Fiscal transfers & fiscal integration
Homogeneous preferences
Commonality of destiny & political integration
OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 14 / 21
A region is optimal as an OCA to the extent it exhibits:
Labour & factor mobility
Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.
Production diversification
Openness
Fiscal transfers & fiscal integration
Homogeneous preferences
Commonality of destiny & political integration
OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 14 / 21
A region is optimal as an OCA to the extent it exhibits:
Labour & factor mobility
Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.
Production diversification
Openness
Fiscal transfers & fiscal integration
Homogeneous preferences
Commonality of destiny & political integration
OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 14 / 21
A region is optimal as an OCA to the extent it exhibits:
Labour & factor mobility
Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.
Production diversification
Openness
Fiscal transfers & fiscal integration
Homogeneous preferences
Commonality of destiny & political integration
OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 14 / 21
Specialisation versus “Endogeneity of OCA”
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Due to the need for relatively long time series for the econometric tests, studiesinvestigating OCA properties are by necessity backward looking. Such studies cannot reflecta change in policy preferences, or a switch in policy regime. In fact, monetary integrationwould represent a structural break for any group of countries adopting a new single currency.A question naturally arises: what type of forces might monetary integration unleash? Lookingahead, we may be confronted with two distinct paradigms -- specialisation versus endogeneityof OCA -- which have different implications on the benefits and costs from a single currency.
6. A Tale of Two Paradigms: Specialisation versus “Endogeneity of OCA”
Frankel (1999) singles out two OCA properties as crucial in assessing the net benefitsfrom currency union: their degree of openness, i.e., the extent of reciprocal trade among agroup of partner countries, and their correlation of incomes (capturing over time diverse otherproperties). Countries sharing a high level of eitheropenness or income correlation , butpreferably both properties, will find it beneficial to share a single currency as illustrated inFigure 2. Their trade-off is illustrated by the downward sloping “OCA line” that shows thecombination of openness and correlation of incomes beyond which the advantages from acommon currency would dominate for a group of partner countries. To the left of the OCAline instead the advantages from monetary independence dominate. The US States and thecurrent members of the euro area (according to us) are located on the right of the OCA line:i.e., they draw net benefits from respectively the US dollar and the euro. Among a groupformed by the US, Japan and Europe the advantages from monetary independence wouldinstead dominate: these countries as a group lie instead on the left of the OCA line.
Frankel also notes that the optimum currency area properties evolve over time. Mostauthors agree that reciprocal trade and openness increase among countries sharing a singlecurrency and a common monetary policy in response to a decline in transportation costs and amore stable exchange rate regime. A case in point are the members of the European Unionthat have removed all trade and financial barriers among each other and share a single market.Reciprocal trade has constantly risen among these countries. Statistical estimates usinggravity model of bilateral trade suggest that membership in the EU increases trade with itsmembers by over 60 percent (Frankel and Wei (1998)). There is disagreement thoughconcerning the extent by which income correlation rises or falls following monetary
Advantages ofcommon currencydominate
Advantages ofmonetaryindependencedominate
OCA Line
Extent of trade among membersof group (Openness)
Correlation ofincomesamong group
Figure 2. Two Key Optimum Currency Area Properties
JapanEU
USA
SwedenUK
Denmark
EuroArea
USStates
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 15 / 21
Part Three of Four. Costs and Benefits of EMU.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 16 / 21
Costs of EMU
1 Loss of Flexibility: can’t devalue, less autonomous monetary policy forall
2 Asymmetric Effects of macro shocks
PO PC
YOYC
DO
SO
DC
SC
Very open country Relatively closed country
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 17 / 21
Benefits of EMU
Lower transactions costs
More price transparency
Less uncertainty
More economic growth
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 18 / 21
Part Four of Four. Wome!
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 19 / 21
Cool example of EMU: Rome
The first European monetary union was the Roman Empire.
Throughout a geographical area larger than today’s EU, Roman coinscame to be the predominant medium of exchange.
The widespread use of Roman money was due in part to the presenceof Roman occupying forces, but also to the increased amount ofinternational trade across the empire. Rome did not decree its money.
This common currency area broke down around the end of 5thcentury AD.
The single most important reason for the breakdown was almostcertainly the loss of financial and political control by the Romans.
Rising political instability made trade more risky and difficult so thatinternational trade integration fell.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 20 / 21
Cool example of EMU: Rome
The first European monetary union was the Roman Empire.
Throughout a geographical area larger than today’s EU, Roman coinscame to be the predominant medium of exchange.
The widespread use of Roman money was due in part to the presenceof Roman occupying forces, but also to the increased amount ofinternational trade across the empire. Rome did not decree its money.
This common currency area broke down around the end of 5thcentury AD.
The single most important reason for the breakdown was almostcertainly the loss of financial and political control by the Romans.
Rising political instability made trade more risky and difficult so thatinternational trade integration fell.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 20 / 21
Cool example of EMU: Rome
The first European monetary union was the Roman Empire.
Throughout a geographical area larger than today’s EU, Roman coinscame to be the predominant medium of exchange.
The widespread use of Roman money was due in part to the presenceof Roman occupying forces, but also to the increased amount ofinternational trade across the empire. Rome did not decree its money.
This common currency area broke down around the end of 5thcentury AD.
The single most important reason for the breakdown was almostcertainly the loss of financial and political control by the Romans.
Rising political instability made trade more risky and difficult so thatinternational trade integration fell.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 20 / 21
Cool example of EMU: Rome
The first European monetary union was the Roman Empire.
Throughout a geographical area larger than today’s EU, Roman coinscame to be the predominant medium of exchange.
The widespread use of Roman money was due in part to the presenceof Roman occupying forces, but also to the increased amount ofinternational trade across the empire. Rome did not decree its money.
This common currency area broke down around the end of 5thcentury AD.
The single most important reason for the breakdown was almostcertainly the loss of financial and political control by the Romans.
Rising political instability made trade more risky and difficult so thatinternational trade integration fell.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 20 / 21
Cool example of EMU: Rome
The first European monetary union was the Roman Empire.
Throughout a geographical area larger than today’s EU, Roman coinscame to be the predominant medium of exchange.
The widespread use of Roman money was due in part to the presenceof Roman occupying forces, but also to the increased amount ofinternational trade across the empire. Rome did not decree its money.
This common currency area broke down around the end of 5thcentury AD.
The single most important reason for the breakdown was almostcertainly the loss of financial and political control by the Romans.
Rising political instability made trade more risky and difficult so thatinternational trade integration fell.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 20 / 21
Next Time
Growth and development effects in the EU. The logic of growth effects,
medium term effects & long term effects.
Baldwin & Wyplosz, Chapter 7.
Badinger, H. Technology and Investment-led growth effects of
economic integration. Applied Economics Letters, 15(7), 557-61,
2008.
Jones, C. I. Introduction to Economic Growth, McGraw Hill, 2008.
Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 21 / 21