Monetary integration

José Villaverde CastroUniversidad de Cantabria

This slides are based on the book “Economics of Monetary Union”, by P. De Grauwe. OUP.

Outline of the presentation

–Degrees of economic integration–Concept of a monetary union–The costs of a monetary union–The benefits of a monetary union–Costs and benefits compared

Degrees of economic integration

No visible trade restrictions

Common external trade restrictions

No invisible trade restrictions

Free mobility of factors and assets

Common currency

Common economic policy

Free trade area X

Custom union X XInternal commodity market X X X

Common market X X X X

Monetary union X X X X X

Economic union X X X X X X

– Common currency– Common central bank

Concept of a monetary union

The costs of a common currency

• Costs arise because, when joining a monetary union, a country looses policy instrument: monetary policy (e.g. exchange rate, interest rate)

• This is costly when asymmetric shocks occur

• Sources of asymmetry: – Shifts in demand– Different preferences between inflation and

unemployment

Shifts in demand (Mundell)

• Assume two countries, France and Germany

• Asymmetric shock in demand– Need to distinguish between permanent and

temporary shock– Decline in aggregate demand in France– Increase in aggregate demand in Germany

• We will analyze this shock in two regimes– Monetary union– Monetary independence

PF PG

YF YG

France Germany

Aggregate demand and supply in France and Germany

DFDG

SF

SG

• How can France and Germany deal with this shock if they form a monetary union?

• Thus France cannot stimulate demand using monetary policy; nor can Germany restrict aggregate demand using monetary policy

• Do there exist alternative adjustment mechanisms in monetary union?– Wage flexibility– Labour mobility

First regime: monetary union

PF PG

YF YG

France Germany

The automatic adjustment process (Wage flexibility)

PF PG

YF YG

France Germany

Second regime: Monetary independence

DFDG

SF

SG

• Thus, when asymmetric shocks occur• And when there are a lot of rigidities• Monetary union may be more costly

than monetary independence• What about fiscal policies? (income

transfers between countries or between generations)

Conclusion

Fiscal policy

Automatic stabilisers: Centralised budget or decentralised budget

•Centralised budget allows for automatic transfers between countries of the monetary union•Decentralised: flexible national budgets

– France allows deficit to accumulate; Germany allows surplus

– This imples automatic transfers between generations within the same countries

– Create problems of debt accumulation and sustainability

Other sources of asymmetry (In the response to shocks)

• Different labour market institutions (supply shocks): Centralized versus non-centralized wage bargaining.

• Different financial systems• Different growth rates• Different fiscal systems: Goverment budget

constraint: (G-T-rB= dB/dt + dM/dt)

PF PG

YF YG

France Germany

Symetric shocks in a monetary union

The benefits of a common currency

•The costs of EMU have mostly to do with macroeconomic management•The benefits are mostly microeconomic in nature: they arise from efficiency gains

Sources of benefits

• Less transactions costs: Direct and Indirect effects (Price transparency)

• Less uncertainty: No exchange rate risk

• Benefits of an international currency• Does monetary union lead to more

economic growth?

Less transactions costs

• Elimination of foreign exchange markets within union eliminates cost of exchanging one currency into another

• Cost reductions amount to 0.25 to 0.5% of GDP (according to European Commission)

Price transparency

• One common unit of account facilitates price comparisons: Consumers “shop around” more.

• Competition increases.• Prices decline and consumers gain.

Less exchange risk

• Euro eliminates exchange risk. Less uncertainty. Increase welfare– Does the decline in exchange risk

increase welfare?

Benefits of an international currency

• International use of the dollar creates seigniorage gains for the US

• Similarly, if euro becomes an international currency, seigniorage gains will follow for Euroland

• These gains, however, remain relatively small:– in the case of the US: less than 0.5% of GDP per

year

Benefits of monetary union and openness

Benefits(% of GDP)

Trade (% of GDP)

Benefits of monetary union are likely to be larger for relatively open economies

In absence of monetary union, transactions costs and exchange risk are larger for firms in very open economies

Monetary union will be more beneficial for firms in very open economies

Upward sloping benefit line

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, and are more resilient

Costs and benefits of a monetary union

Benefits

CostsCo

sts

and

Ben

efit

s (%

GD

P)

Trade (% GDP)

Two views about costs and benefits of MU

Trade (% GDP) Trade (%GDP)

Cos

ts a

nd b

enef

its

Cos

ts a

nd b

enef

its

Benefits

Costs

Costs

Benefits

T* T*

(a) The monetarist view (b) The Keynesian view

Two views about costs of MU

• The 'monetarist‘ view : – Monetary policies are ineffective as

instruments to correct for different developments between countries.

– The cost curve is close to the origin. – Thus, many countries in the world

would gain by relinquishing their national currencies, and by joining a monetary union.

• The 'Keynesian' view :– the world is full of rigidities– Monetary policy (including exchange

rate policy) is a powerful instrument in eliminating disequilibria

– the cost curve is far away from the origin

– relatively few countries should find it in their interest to join a monetary union

Costs and benefits with decreasing rigidities

Cos

ts a

nd b

enef

its

Trade (% GDP)

T* T**

Benefits

Costs

With decline in wage and price rigidities and an increase in labour mobility:

Cost curve shifts downwards

Monetary union becomes more attractive