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Robert Mundell The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1999 “ for his analysis of monetary and fiscal policy under different.

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Presentation on theme: "Robert Mundell The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1999 “ for his analysis of monetary and fiscal policy under different."— Presentation transcript:

1 Robert Mundell The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1999 “ for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas ”

2 Mundell American Economic Review 1961 From Press Release - The Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel As already indicated, fixed exchange rates predominated in the early 1960s. A few researchers did in fact discuss the advantages and disadvantages of a floating exchange rate. But a national currency was considered a must. The question Mundell posed in his article on "optimum currency areas" (1961) therefore seemed radical: when is it advantageous for a number of regions to relinquish their monetary sovereignty in favor of a common currency?

3 Mundell's article briefly mentions the advantages of a common currency, such as lower transaction costs in trade and less uncertainty about relative prices. The disadvantages are described in greater detail. The major drawback is the difficulty of maintaining employment when changes in demand or other "asymmetric shocks" require a reduction in real wages in a particular region. Mundell emphasized the importance of high labor mobility in order to offset such disturbances. He characterized an optimum currency area as a set of regions among which the propensity to migrate is high enough to ensure full employment when one of the regions faces an asymmetric shock. Other researchers extended the theory and identified additional criteria, such as capital mobility, regional specialization and a common tax and transfer system. The way Mundell originally formulated the problem has nevertheless continued to influence generations of economists.

4 Mundell's considerations, several decades ago, seem highly relevant today. Due to increasingly higher capital mobility in the world economy, regimes with a temporarily fixed, but adjustable, exchange rate have become more fragile; such regimes are also being called into question. Many observers view a currency union or a floating exchange rate - the two cases Mundell's article dealt with - as the most relevant alternatives. Needless to say, Mundell's analysis has also attracted attention in connection with the common European currency. Researchers who have examined the economic advantages and disadvantages of EMU have adopted the idea of an optimum currency area as an obvious starting point. Indeed, one of the key issues in this context is labor mobility in response to asymmetric shocks.

5 Sources of benefits Less transactions costs Price transparency Less uncertainty Benefits of an international currency

6 Less transactions costs Elimination of exchange markets within union eliminates cost of exchanging one currency into another Cost reductions amounts to 0.25 to 0.5% of GDP (according to European Commission) Fulls cost reduction only achieved when payments systems are fully integrated

7 Price transparency One common unit of account facilitates price comparisons Consumer “shop around” more Competition increases Prices decline and consumers gain

8 Less exchange risk Euro eliminates exchange risk.

9 Exchange rate uncertainty and the price mechanism Large exchange variability reduces the quality of price signals in allocating resources Example: large overvaluation of dollar in 1980s led to decline of export sector; a decline that turned out to be unnecessary once the dollar declined again. These large real exchange rate cycles lead to large adjustment costs

10 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

11 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

12 Economic Integration and the Benefits of a Fixed Exchange Rate Area: GG Schedule –Monetary efficiency gain The joiner’s saving from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float. It is higher, the higher the degree of economic integration between the joining country and the fixed exchange rate area. –GG schedule It shows how the potential gain of a country from joining the euro zone depends on its trading link with that region. It slopes upward. The Theory of Optimum Currency Areas

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14 Costs De Grauwe Chapter 1

15 Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule –Economic stability loss The economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. It is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins. –LL schedule It shows the relationship of the country’s economic stability loss from joining. It slopes downward. The Theory of Optimum Currency Areas

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17 The Decision to Join a Currency Area: Putting the GG and LL Schedules Together –The intersection of GG and LL Determines a critical level of economic integration between a fixed exchange rate area and a country Shows how a country should decide whether to fix its currency’s exchange rate against the euro The Theory of Optimum Currency Areas

18 What Is an Optimum Currency Area? –It is a region where it is best (optimal) to have a single currency. –Optimality depends on degree of economic integration: Trade in goods and services Factor mobility –A fixed exchange rate area will best serve the economic interests of each of its members if the degree of output and factor trade among them is high. The Theory of Optimum Currency Areas

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20 Is Europe an Optimum Currency Area? –What do the data tell us? The Theory of Optimum Currency Areas

21 20-21 Fig. 20-7: Intra-EU Trade as a Percent of EU GDP

22 FIGURE 20-3 Importance of EU trade for EU countries, Miles & Scott/Macroeconomics: Understanding the Wealth of Nations Chapter 20, Figure 20-03

23 20-23 Table 20-3: Current Account Balances of Euro Zone Countries, 2005–2009 (percent of GDP)

24 The Theory of Optimum Currency Areas

25 GDP correlation Correlation with EU GDP

26 FIGURE 20-4 Correlation of GDP in EU countries. Miles & Scott/Macroeconomics: Understanding the Wealth of Nations Chapter 20, Figure (Figure continues on next 2 slides)

27 FIGURE 20-4 (Continued) Miles & Scott/Macroeconomics: Understanding the Wealth of Nations Chapter 20, Figure continued (Figure continues on next slide)

28 FIGURE 20-4 (Continued) Miles & Scott/Macroeconomics: Understanding the Wealth of Nations Chapter 20, Figure continued

29 FIGURE 20-5 Correlation of output among U.S. regions. Miles & Scott/Macroeconomics: Understanding the Wealth of Nations Chapter 20, Figure 20-05

30 One answer –Europe is not an optimum currency area: »Most EU countries export from 10% to 20% of their output to other EU countries. »EU-U.S. trade is only 2% of U.S. GNP. »Labor is much more mobile within the U.S. than within Europe. »Federal transfers and changes in federal tax payments provide a much bigger cushion for region-specific shocks in the U.S. than do EU revenues and expenditures.

31 Another answer –Europe is an optimum currency area: »Intra EU trade is the big part of international trade. »High correlations between GDP of EU economies


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