Presentation on theme: "Optimal Currency Area Theory"— Presentation transcript:
1 Optimal Currency Area Theory The Case of Sweden and the EMUIthurbide: Prévision des taux d’échangeGyörgyi Kacsandi, Signe Svensson, Stefan Zeugner, 2002
2 Overview Question Theory Case Application: Sweden DISPOSITIONOverviewQuestionTheoryWhat is an asymmetric shock?OCA CriteriaCase Application: SwedenStatistic StudyConclusionAcademic Results
3 Is the EMU an Optimum Currency Area for Sweden? QUESTIONIs the EMU an Optimum Currency Area for Sweden?
4 Time line 1995 Sweden joins the EU QUESTIONTime line1995 Sweden joins the EU1996 The Swedish Government launches «Wait and See» Policy considering EMU1999/2002 The EMU is put into reality by the introduction of the Euro in the 12 member states2002 Swedish prime minister says that the smooth introduction of the euro advances the date of a possible referendum to not later than 2005, and most likely 2003.
5 Why Sweden adopted « Wait and See » policy in 1996: QUESTIONWhy Sweden adopted « Wait and See » policy in 1996:Financial Situation of the StateThe Rate of UnemploymentNot Sufficient Debate; LegitimacyOther EU-countries
6 Definition An Optimum Currency Area is an area THEORYDefinitionAn Optimum Currency Area is an areaneither so small and open that it would be better off pegging its currency to a neighbor,nor so large that it would be better off splitting into sub-regions with different currencies.
7 What is an asymmetric shock? THEORYWhat is an asymmetric shock?
8 Assumptions:Price levels stick to their initial levelInitial current account is balancedAsymmetric shock:Productivity increase in Airbus productionTHEORYCamembert SupplyqpqpAirbus DemandPCAirbus SupplyCamembert DemandPAExcess supply for AirbusExcess demand for Camembert
9 I. Flexible Exchange Rates THEORYI. Flexible Exchange RatesFrance is devided into two currency areas: in the Northeast the NE-Franc and in the Southwest the SW-Franc:In the booming Northeast, interest rates rise – whereas in the staggering Southeast they fall. The NE-Franc appreciates versus the SW-Franc and the justified prices are quickly reached on « international » markets.But there is no inflation in the NE and no monetary-caused unemployment in the SW.Moreover, each region can fine-tune its monetary policy to its particular shock.
10 II. Fixed Exchange Rates: THEORYII. Fixed Exchange Rates:Labor mobilityIn order to decrease the excess supply of Airbuses, workers will « quit » their jobs in the Southwes, move to the Northeast and will become Camembert producers.Camembert supply will increase (shift to the right), Airbus supply will decrease (shift to the left)Þ The price movements are by far not as excessive as in case I.
12 III. Fixed Exchange Rates: THEORYIII. Fixed Exchange Rates:Adjustment of PricesLabor productivity has increased Þ one needs less work hours to build an Airbus (relative to work hours for making Camembert) Þ The price of an Airbus in terms of Camemberts falls Þ the producers (workers) of Airbuses receive less Camemberts in total (real wage)i.e. incomes in the Southwest deteriorate, while the Northeast is experiencing a boom. This implies falling wages (along with the prices) in the Southwest – or unemployment. The Northeast will suffer from inflation.
14 Why should France have a common currency? THEORYWhy should France have a common currency?Decision rule: Common currency if the advantages > disadvantages in the long runAdvantagesReduce transaction costs and exchange rate riskProvide a nominal anchor for nominal policyDisadvantagesNo independent monetary policyi.e. if France forms an Optimal Currency Area!
15 Fixed Exchange Rates – Common Currency THEORYFixed Exchange Rates – Common CurrencyReducing the risk of assymetric shocks:Symmetric disturbances Þ business cycle correlationHigh trade integration leads to higher income correlationProduct diversification in the regionDampening the effects of assymetric shocks:Labor mobilityPrice flexibilty Þ wage flexibiltyHigh trade integration (because of the marginal propensity to consume)Fiscal federalism
16 The Case of EMU and Sweden CASE APPLICATIONThe Case of EMU and SwedenLabor mobility:Currently 1.9% of labor force in EU countries comes from another EU member state. In the U.S., 1,5% of population are moving inter-state every year!Fiscal Federalism:If a U.S. state suffers an income shock, it will be compensated for 40% of the loss by fiscal federalism (less taxes, more subsidies). The EU budget is limited to 1.27% of EU-GDP.
17 Fixed Exchange Rates – Common Currency CASE APPLICATIONFixed Exchange Rates – Common CurrencyReducing the risk of assymetric shocks:Symmetric disturbances -> business cycle correlationHigh trade integration leads to higher income correlationSectoral diversification in the regionDampening the effects of assymetric shocks:Labor mobilityPrice flexibilty -> wage flexibiltyHigh trade integration (because of the marginal propensity to consume)Fiscal federalism
18 Four main criteria for OCA of Sweden and EMU CASE APPLICATIONFour main criteria for OCA of Sweden and EMUSectoral diversificationCorrelation of income cyclesHigh trade integrationSimilarity in price and wage patterns
25 CONCLUSIONOur conclusionThe criteria are not sufficiently fulfilled to make the EMU an Optimum Currency Area for SwedenHowever, the development shows that the EMU might be so in the futureIf Sweden chooses to join for political reasons,Þ Sweden might suffer asymmetric shocks due to the little correlation to the other EMU countriesÞ Sweden should try to achieve increased price and wage flexibility to damp the socio-economic costs of OCA
26 Academic results (Rose, 2001) AssumptionsTrade patterns and income correlations are endogenous – what happens in the long run?How?Econometric research on trade streamsResult?Participating in a common currency area has a large positive impact on trade, which can be quantified.
27 Prognosis? Statistic results ACADEMIC RESULTSStatistic results(Rose, 2001) cont.Prognosis?If Sweden joins the EMU for political reasons, it will be more likely to fulfill the OCA Criterions in the futureEntering the EMU would alsoÞ increase Swedish trade with the EU by %Þ increase Swedish GDP by about 11 %