9: A Single Currency: Some Theory
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Some mechanics of exchange rates
• A depreciation (apreciation) of the € wrt the $
implies that you need more (less) € to buy 1$. The
€ is weaker (stronger) vis-à-vis the $.
• A depreciation (apreciation) of the € reduces
(increases) the $ price of EU goods making them
more (less) competitive.
• A depreciation (apreciation) of the € increases
(decreases) the $ price of US goods making them
less (more) competitive.
• Markets depreciate or apreciate while
governments devalue or revalue their currencies.
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The Macroeconomy: AD & AS
• AD = C+I+G+(X-M) where C=f(Yd), I=f(i),
X=f(Yf), M=f(Yd).
• AS = f(production function)
• AD=AS
• Slope of AS reflects how tight the production
function is.
• Position of AD vis-a-vis slope of AS determines
how inflationary is expansionary fiscal and
monetary policy (horizontal versus vertical AS
curve).
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A good question, no simple answer
• Should currency area borders coincide with national
borders?
– Should EU countries have their own currencies?
– Is it a good idea for California to use the US dollar?
• Late 1980s end of cold war hit military spending (includes high-tech
equipment). California more affected and suffers greater reduction in
economic growth than the rest of the US (cyclical downturn).
• Mid 1990s technological innovation in information technology
benefited California dispoportionately.
• If California had its own currency:
– It could have depreciated in the 80s and appreciated in the 90s. A depreciation
increases net exports and so stimulates AD. An appreciation reduces net exports
and so reduces AD thereby cooling the economy (and prices).
– It could also had reduced interest rates in the 80s and increased them in the 90s
(affecting I and C and thus AD).
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In a nutshell
• The benefits
– No need to change currency (time, commissions)
– Reduction of uncertainty in international trade and
investment:
• Mounting evidence that eliminating exchange rate volatility by
adopting a common currency raises trade a lot. Estimates range
from 50% to 100%.
• The costs (OCA theory; Robert Mundell)
– Loss of monetary and exchange rate instruments
• Matters in presence of:
– Asymmetric shocks
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Asymmetric shocks
• Simplest example: an adverse demand
shock on France (people switch from
French to German goods): how can the
exchange rate help?
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Implications of asymmetric shocks
•
•
•
•
In France: national income falls, unemployment
increases, trade deficit worsens.
In Germany: national income increases, trade surplus,
inflationary pressures.
With separate currencies France could devalue, promote
exports and thus restore income. Could also reduce
interest rates to stimulate the economy. Germany could
revalue and increase interest rates. With common
currency, don’t have these instruments.
Important questions to fathom the seriousness of the
problem:
– The availability of other instruments. 4 OCA criteria.
– What is the likelihood of asymmetric shocks?
– Is the exchange rate really effective?
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Criterion 1: Labour mobility
• Countries with high labour mobility among them
may form and OCA. Why?
– French unemployed move to Germany for work:
–
–
This reduces u/e in France and improves trade deficit
(less French demanding imports).
It also reduces inflationary pressures in Germany.
– Caveats
–
–
Labour mobility is relatively easy within national
borders (culture, language, legislation, welfare, etc…)
An international comparison suggests that labour
mobility is low in Europe
» Across countries
» Even within countries
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Criterion 2: Wage flexibility
• Preliminaries: Fall in AD in France means a leftward shift
of Ld curve. At prevailing wages have unemployment
(show graphically).
• As a result expecte a fall in wages in France, and french
companies gain in competitiveness and the economy
recovers. (Labour market adjustment).
• In Germany, wages rise, German firms lose
competitiveness and the economy does not over-heat.
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Criterion 2: Wage flexibility
• Mobility may not change much, but wages
could become less sticky
• Two views:
– The virtuous circle: labour markets respond to
enhanced competition by becoming more
flexible.
– The hardening view: labour markets respond to
enhanced competition by increasing protective
measures that raise stickiness
• The jury is still out
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Criterion 3: Fiscal transfers
• Take higher tax revenue in Germany and
transfer it to France:
– Reduces inflationary pressures in Germany
– Increases Demand in France.
• Transfers can act as an insurance that
mitigates the costs of an asymmetric
shock.
• Transfers exist within national borders
– Implicitly through the welfare system
– Explicitly in federal states
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Criterion 3: Fiscal transfers
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Criterion 3: Fiscal transfers
• The EU does not satisfy the transfer
criterion
• The overall EU budget
– is low, capped at 1.27% of EU GDP
– entirely used for administration, CAP, regional
and structural funds
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Criterion 4: Commonality of destiny
• Countries that view themselves as
sharing a common destiny better accept
the costs of operating an OCA
• A common currency will always face
occasional asymmetric shocks that result
in temporary conflicts of interests
– This calls for accepting such economic costs
in the name of a higher purpose
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Incidence of Asymmetric shocks
• Asymmetric shocks are less likely if
countries’ production and exports are
widely diversified and of similar
structure. Why?
• Importance of intra versus inter industry trade.
• Comparative advantage, Commission, Krugman
(see next slide).
• No firm conclusion so far: economic integration
seems to favor intra-industry trade but there is
also a core periphery effect (EMU is another
step in this direction).
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Incidence of Asymmetric shocks
Divergence
Krugman view
Comssion view
Trade Integration
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Exchange rate effectiveness: Openness
• Countries which heavily rely on imports
in their production process have little use
for their exchange rate. Why?
– If they devalue to become more competitive
it only feeds into greater import and thus
production costs and thus a loss of
competitiveness (see following graph)
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Exchange rate effectiveness: Openness
•P
•S’F
•SF
•F’
•F
•D’F
•DF
•YF
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Are the other criteria endogenous?
• Transfers
– Currently no support for more taxes to finance
transfers.
• Commonality of destiny
– No presumption that it will change soon.
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In the end
• Monetary union is not only about
economics. The history of EMU points to
the importance of politics:
– 1990 unification of Germany opens door to a ‘grand
bargain’ (Mitterrand, Kohl).
• Germany gives up DM for European Monetary Union & East
Germany joins the EU without negotiation.
• The economic analysis tells us what the
economic costs and benefits will be.
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