The economics of monetary union. The feasibility of absorbing asymmetric shocks.. 1

The economics of monetary union Starting point - economic integration in the EU: → unprecedented stage of development of the European integration process and the question of its future: What is the EU in terms of its model of economic integration? customs union → common market → economic and monetary union the old 1990s and the current debate on the final stage of European integration: is a monetary union possible without full economic union? 2

The economics of monetary union Stages of economic integration – based on the Balassa’s model: 3

The economics of monetary union What constitutes a monetary union? – common market (including capital market integration) + an exchange rate union: → complete and irrevocable convertibility of national currencies and complete liberalization of the capital market (no exchange controls for both current and capital account transactions); → permanently and irrevocably fixed exchange rates of the MU’s countries (in some cases supplemented by a common currency); → common monetary and exchange rate policy – in a MU with a common currency conducted by a supranational central bank. 4

The economics of monetary union What constitutes an economic union in theory? → common market, → monetary union with a common monetary policy and: → unification of economic policies. But: What is the scope of economic policy unification? What are the forms of economic policy unification? The EU’s response? What are the goals of economic policy unification? 5

The economics of monetary union 6 The European Union 2011:

The economics of monetary union The monetary part of EMU: → the Euro + the European Central Bank (common monetary policy) + common exchange rate policy The economic part of EMU (the 1989 Delors Report): → the single market within which persons, goods, services and capital can move freely; → competition policy and other measures aimed at strengthening market mechanisms; → common policies aimed at structural change and regional development; → macroeconomic policy coordination, including binding rules for budgetary policies. 7

The economics of monetary union Starting point of our analysis revisited - economic integration in the EU: →EMU escapes simple model classifications: monetary union with certain elements of economic union → supranational monetary and mainly intergovernmental economic component of EMU, →Is the EMU’s economic component enough to achieve the goals of European integration? the position of price stability among other goals of economic policy of the EU and its Member States. 8

The economics of monetary union Starting point of our analysis revisited - economic integration in the EU: Art. 3.3 ToFEU: The Union shall establish an internal market. It shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment. It shall promote scientific and technological advance. 9

The economics of monetary union Starting point of our analysis revisited - economic integration in the EU: Art and 3 ToFEU: 2. Concurrently with the foregoing, and as provided in the Treaties and in accordance with the procedures set out therein, these activities shall include a single currency, the euro, and the definition and conduct of a single monetary policy and exchange-rate policy the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Union, in accordance with the principle of an open market economy with free competition. 3. These activities of the Member States and the Union shall entail compliance with the following guiding principles: stable prices, sound public finances and monetary conditions and a sustainable balance of payments. 10

The economics of monetary union How to minimize the risk of such a conflict of economic policy goals? – economic theory comes to the rescue: →concise manual of the optimum currency area theory: what are the costs of monetary integration and how to reduce them? →definition of an optimum currency area: introduction of a common currency does not reduce welfare (defined in terms of production and employment in national economies): countries are „better off” with the common currency than they used to be prior to its adoption. 11

The feasibility of absorbing asymmetric shocks OCA theory – an introduction: → foundations of the OCA theory: 1.R. A. Mundell, „A theory of optimum currency areas”, American Economic Review, Nr 4, Vol. 51/ R. I. McKinnon, „Optimum currency areas”, American Economic Review, 53/ P. B. Kenen, „The theory of optimum currency areas: an eclectic view”, w: „Monetary problems of the international economy”, eds. R. A. Mundell, A. K. Svoboda, The University of Chicago Press, Chicago

The feasibility of absorbing asymmetric shocks OCA theory – an introduction: → the loss of monetary policy autonomy as the primary cost of monetary integration: the question of limited national macroeconomic stabilisation measures; → When is the loss of monetary policy autonomy particularly painful? -the problem of symmetric and asymmetric macroeconomic shocks in a MU: symmetric shocks: shocks common (similar) to all the MU’s member states – may be absorbed by a common supranational monetary policy; asymmetric shocks: country-specific shocks – national economies have to adjust without the use of supranational monetary policy by the common central bank. 13

The feasibility of absorbing asymmetric shocks OCA theory – Mundell’s three asymmetric shock examples: 1. two independent countries (two national currencies) without international factor mobility:  starting point: fixed exchange rates, full employment and balance of payment equilibrium;  negative, asymmetric demand shock: a decrease in demand for goods produced in country B and an increase in demand for goods produced in country A. 14

The feasibility of absorbing asymmetric shocks OCA theory – Mundell’s three asymmetric shock examples: 1. two independent countries (two national currencies) without international factor mobility:  the negative demand shock will cause unemployment in country B and inflation pressure in country A;  if country A accepts inflation, the change in terms of trade will reduce adjustment costs in country B (its products will be relatively cheaper);  if country A chooses restrictive monetary policy to prevent inflation, the total cost of adjustment will be borne by country B: decrease in output and employment will be inevitable. 15

The feasibility of absorbing asymmetric shocks OCA theory – Mundell’s three asymmetric shock examples: 1. two independent countries (two national currencies) without international factor mobility: Conclusion: With fixed exchange rates, anti-inflationary policy conducted by a country facing positive demand shock will fortify the recessionary impulse in a country facing decrease in demand for its goods. 16

The feasibility of absorbing asymmetric shocks OCA theory – Mundell’s three asymmetric shock examples: 2. One country having its own currency but consisting of two separate economic regions (defined in terms of lack of factor mobility between the two regions):  starting point: full employment and balance of payment equilibrium;  negative, asymmetric demand shock: a shift in demand from goods produced in region B to goods produced in region A;  problem for the central bank: in order to reduce unemployment in region B, the money supply should be raised, but expansive monetary policy will aggravate inflationary pressure in region A. 17

The feasibility of absorbing asymmetric shocks OCA theory – Mundell’s three asymmetric shock examples: 2. One country having its own currency but consisting of two separate economic regions (defined in terms of lack of factor mobility between the two regions): Conclusion: There is a trade-off between unemployment in a region facing negative demand shock and inflation in a region struggling with inflationary pressure. 18

The feasibility of absorbing asymmetric shocks OCA theory – Mundell’s three asymmetric shock examples: 3. Two countries having separate currencies, consisting of two economic regions (eastern and western), whose borders do not overlap political borders:  negative demand shock occurs in the eastern region;  problem: unemployment in the eastern region and inflationary pressure in the western region;  in order to reduce unemployment in the eastern region, the central banks should increase money supply, but if they decide to prevent inflation in the western region –monetary restriction is advised;  there is a Philips curve-type trade off between inflation and unemployment… 19

The feasibility of absorbing asymmetric shocks What do those three examples have in common with monetary integration theory? → in all cases, exchange rate policy was not used to stabilize the economies facing asymmetric shocks (in example 1, the exchange rates of the two countries were fixed, in example 2 – there was only one country with one currency, but consisting of two separate regions, in example 3 - the borders of the economic regions did not overlap political borders – so exchange rate adjustment was not considered 20

The feasibility of absorbing asymmetric shocks What do those three examples have in common with monetary union theory? → The costs of the loss of exchange rate policy autonomy: nominal exchange rate adjustment could be an easier adjustment tool to use than inflation or unemployment: (depreciation of the currency of a country facing negative demand shock should improve the situation on its labor market and reduce inflationary pressure in a country, whose currency appreciated). 21

The feasibility of absorbing asymmetric shocks The problem of costs of monetary integration: → the costs of loss of exchange rate and monetary policy autonomy are the higher the more asymmetric are the macroeconomic shocks in a monetary union. Why? → if a common currency is adopted, the monetary union’s central bank is not able to adjust its monetary policy reacting to country-specific shocks (the problem of „one-size-fits-all” policy); 22

The economics of monetary union How should a successful monetary union be created? 23

The economics of monetary union OCA theory in a (very) small pill: →to select ex ante (prior to the adoption of the common currency) a group of countries, for which the probability of asymmetric shocks is low + ensuring mechanisms of macroeconomic stabilisation other than monetary and exchange rate policy (the Mundell-McKinnon-Kennen criteria and their complements). →the endogeneity hypothesis in the OCA theory. 24

The economics of monetary union The traditional OCA criteria: 1)labor market flexibility:  wage flexibility  mobility of labor 2) openness of a country’s economy, 3) diversification of production. 25

The economics of monetary union The traditional OCA criteria: the importance of labor market flexibility:  wage flexibility: unemployed workers will reduce their wage claims → with lower wages, prices of goods will also be reduced → cheaper products will be more competitive which will restore demand and bring the economy back to equilibrium wages in countries (regions) facing an increase in demand will rise → more expensive products will be less competitive → demand will decrease  mobility of labor: unemployed workers from one country (region) may move to the country (region) where there is an increase in demand → thus, both problems of unemployment are solved (increased labor supply will result in reducing wages). 26

The economics of monetary union The traditional OCA criteria: openness of a country’s economy:  openness of the economy – the degree to which a country is integrated with the rest of the world (eg. the share of foreign trade – or to be more precise: tradeables and non-tradeables - in GDP);  the more open a country’s economy, the more unlikely are the asymmetric shocks (trade makes countries similar in terms of shocks affecting their economies and business cycles → symmetric shocks may prevail in groups of highly integrated countries);  the more open the economy, the higher the costs of flexible exchange rate: any exchange rate adjustment has greater influence on domestic prices than in case of an relatively closed economy. 27

The economics of monetary union The traditional OCA criteria: diversification of production:  when many different goods are traded, decreases in demand on some markets are offset by increases in demand on other markets → even if demand shocks are asymmetric, they will be less acute in a multi-product economy than in an economy producing and exporting only one product (type of products). 28

The economics of monetary union Does the fulfillment of traditional criteria of optimum currency area optimality guarantee stabilization of output and employment in monetary union’s member states? 29

The economics of monetary union How to conclude discussion on traditional OCA criteria?  even if the risk of asymmetric shocks is reduced in economies fulfilling OCA criteria, they are not totally eliminated…  practical problem: there is no universal „OCA optimality” test allowing us to quantify the readiness of particular countries to join a monetary union (economists often use cyclical convergence as an OCA optimality test)  if asymmetric shocks are inevitable and labor markets are not flexible enough, there must be some additional stabilisation mechanisms available in a monetary union… 30

The economics of monetary union Additional economic criterion of currency area optimality: Effective use of fiscal policy to stabilize the economy in case of asymmetric shocks 31

The economics of monetary union Fiscal policy in a monetary union – how to define its proper layout?  assuming the loss of monetary and exchange rate policy autonomy, fiscal policy remains a possible macroeconomic stabilisation (aggregate demand management) tool to be used in case of asymmetric shocks;  But: should fiscal policy in a monetary union be supranational – or on the contrary, should it remain at a national level?  In case of the EU, fiscal union has not been politically acceptable so far – therefore fiscal policy is only subject to coordination (the negative external effects of national fiscal policies should be reduced + countries should be able to develop „room for maneuver” – ability to use expansionary fiscal policy in a recession) 32

The economics of monetary union Additional political criteria for currency area optimality: 1.Homogeneity of preferences in a monetary union (with respect to unemployment, inflation, exchange rate of the common currency). 2.Common vision of the future of the integration process. 33

The economics of monetary union How to assess the EMU in terms of OCA theory? → Different goals of economic policy: OCA theory: emphasis on the level of production and employment in national economies adopting the common currency EMU: emphasis on price stability 34

The economics of monetary union How to assess the EMU in terms of OCA theory?  Eurozone countries were not an OCA when they adopted the common currency…  hypothesis of OCA criteria endogeneity: countries that were not an OCA ex ante, may become an optimum currency area ex post→ adoption of a common currency itself may make them more similar in terms of macroeconomic shocks + economic (including fiscal) policy coordination may improve macroeconomic adjustment mechanisms in place in respective member states. 35