1. Monetary integration José Villaverde Castro Universidad de Cantabria
This slides are based on the book “Economics of Monetary Union”, by P. De Grauwe. OUP.

2. 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

3. 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
Internal commodity market
Common market
Monetary union
Economic union

4. Concept of a monetary union
Common currency
Common central bank

5. 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

6. 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

7. Aggregate demand and supply in France and GermanyPF PG SG SF DG DF YG YF

8. First regime: monetary union
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

9. The automatic adjustment process (Wage flexibility)
France
Germany PF PG YF YG

10. Second regime: Monetary independence
France
Germany PF PG SG SF DG DF YG YF

11. Conclusion 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)

12. 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

13. Other sources of asymmetries: Different preferences about inflation and unemployment

14. Germany C B e
Italy A C’

15. 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)

16. Symetric shocks in a monetary union
France
Germany PF PG YF YG

17. 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

18. 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?

19. 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)

20. Price transparency
One common unit of account facilitates price comparisons: Consumers “shop around” more.
Competition increases.
Prices decline and consumers gain.

21. Less exchange risk
Euro eliminates exchange risk. Less uncertainty. Increase welfare
Does the decline in exchange risk increase welfare?

22. Monetary Union and economic growth
Neo-classical growth model y r
f(k) A r k

23. Potential growth effects of monetary union
MU eliminates exchange risk and may reduce systemic risk. If so, real interest rate declines
rr-line becomes flatter (r’r’)
Economy moves from A to B
Per capita income increases because of capital accumulation
Economic growth increases during transition from A to B y r r’ B
f(k) A r’ r k

24. Endogenous growth and monetary union
Capital accumulation can lead to dynamic effects leading to technological innovations.
Production function f(k) then shifts outwards raising economic growth y C
f’(k) B
f(k) A k

25. 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

26. Benefits of monetary union and openness
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
Benefits
(% of GDP)
Trade (% of GDP)

27. The cost of a monetary union and the openness of a country
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
Cost
(% of GDP)
Trade (% of GDP

28. Costs and benefits of a monetary union
Costs and Benefits (% GDP)
Costs
Trade (% GDP)

29. Two views about costs and benefits of MU
(a) The monetarist view
(b) The Keynesian view
Benefits
Benefits
Costs and benefits
Costs and benefits
Costs
Costs T* T*
Trade (% GDP)
Trade (%GDP)

30. 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.

31. 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

32. Costs and benefits with decreasing rigidities
With decline in wage and price rigidities and an increase in labour mobility:
Cost curve shifts downwards
Monetary union becomes more attractive
Benefits
Costs and benefits
Costs T*
T**
Trade (% GDP)