Feb Lesson 5 By John Kennes International Monetary Economics

Feb Optimum Currency Areas

Feb Should currencies coincide with national borders?

Feb Is the US an optimal currency are?

Feb What countries stand to benefit from sharing the same currency? –The OCA theory provides a set of criteria. Are these criteria filled for Europe? –Some critera are filled, but not others –Illustrates the unending debate –Illustrates potential problems that may surface, and suggest some answers. Optimal Currency Area (OCA) theory

Feb Transactions costs –Money is more useful the wider it is excepted 2.Asymmetric shocks –The Case for a California dollar (High tech shocks) –The Case for an Alberta dollar (Oil shocks) Tradeoffs

Feb Benefits –Money exhibits increasing returns to scale (network externatilies) Costs –Loss of monetary and exchange rate instruments –Matters in the presence of: Price and wage stickiness Asymmetric shocks Size matters

Feb Size matters

Feb Start with the idea that there are benefits to a common currency –Few widely excepted models of transaction costs: search models, menu costs models, etc. Still much work needs to be done by theoriests. Need models with explicit welfare functions. Ask why not. Look at the costs. The argument

Feb No precise way of estimating costs and benefits so, in the end, a matter of judgment. Look at asymmetric costs: –How they create trouble –What makes them more likely –What makes them less painful. Estimating costs and benefits

Feb Asymmetric Shocks: How can the exchange rate help?

Feb Adverse Demand shock in a two country currency

Feb Both countries are hurt when they share the same currency. –Also the case when a symmetric shock creates asymmetric effects Next questions: –What reduces the incidence of asymmetric shocks? –What makes it easier to cope with shocks when they occur. –The analysis develops six OCA criteria Implications of Asymmetric shocks

Feb In an OCA labor moves easily across national borders Caveats –Labor mobility is easy within national borders (culture, language, legislation, welfare, etc) –Capital mobility: differences between financial and physical capital –In presence of country specialization, skills also matter Criterion 1 (Mundell): Labor mobility

Feb Countries whose production and exports are widely diversified and of similar structure form an OCA Indeed, in this case, there are few asymmetric shocks and each of them is likely to be a small concern Criterion 2 (Kenen): Production Diversification

Feb Countries which are very open to trade and trade heavily with each other form an OCA. Distinguish between traded and nontraded goods: –Traded good prices are set world wide –A small economy is price taker, so exchange rate does not affect competiveness In the limit, if all goods are traded, domestic gods prices must be flexible and the exchange rate does not affect competiveness. Criterion 3 (McKinnon): Openness

Feb Countries that agree to compensate each other for adverse shock form an OCA Transfers can act as an insurance that mitigates the cost of an asymmetric shock Transfers exist within national borders: –Implicitly through the welfare system –Explicitly in federal states Criterion 4: Fiscal transfers

Feb Countries that share a wide consensus on the way to deal with shocks form an OCA Matters primarily for symmetric shocks: –Prevalent when the Kenen criterion is satisfied May also help with asymmetric shocks: –Better understanding of partners actions –Encourage transfers Criterion 5: Homogeneous Preferences

Feb Criterion 6: Commonality of Destiny

Feb Is Europe an OCA?

Feb Is Europe an OCA? A synthetic OCA index (Bayoumi and Eichengreen 1997)

Feb Read their methodology. How do they incorperate the 6 criteria? Notice that most of the countries at the top of the list did not join the euro in the first round Is Europe an OCA? A synthetic OCA index (Bayoumi and Eichengreen 1997)

Feb Is Europe an OCA? Asymmetric effects of symmetric shocks: effects of GDP and prices of a change of the common interest rate

Feb Note that textbook has misprinted figure 13-6 Is Europe an OCA? Asymmetric effects of symmetric shocks: effects of GDP and prices of a change of the common interest rate

Feb Inside the OCA index Most EU countries are very open McKinnon criteria is broadly satisfied.

Difference in trade structure relative to that of its partners Inside the OCA index: Diversification Most EU countries have diversified production Kenen criterion broadly satisfied

Feb The labor mobility criterion cannot be black and white Inside the OCA index: Labor Mobility

Feb The labor mobility criterion cannot be black and white The migration response to econmic incentives must factor in many costs –Moving costs –Risks of being unemployed –Longer run career prospects –Family prospects –Eligibility for welfare –Taxation –Cultural/ lingusitic difficulties –National attachment Inside the OCA index: Labor Mobility

External migration Inside the OCA index: Labor Mobility International comparisons suggest labor mobility is low in Europe

Internal migration Inside the OCA index: Labor Mobility International comparisons also suggest intranational labor mobility is low in Europe

Feb Low mobility implies that unemployment bears much of the adjustment to shocks A US EU comparison (Fatás 2000) Inside the OCA index: Labor Mobility

EU-US Impulse response (Fatás 2000) Inside the OCA index: Labor Mobility

Feb The EU does not satisfy the transfer criterion The overall EU budget -Is low, capped at 1.27% of EU GDP -Entirely used for administration, CAP, regional and structural funds Inside the OCA Index: Transfers

Feb Little is known about this criterion Inside the OCA Index: Homogeneity of Preferences

Feb Little is known about this criterion Public opinion polls do not dedect deep opposition to EU institutions Inside the OCA Index: Commonality of Destiny

Feb Inside the OCA Index: Commonality of Destiny

Feb OCA-glasset er enten halvt tomt eller halvt fyldt

Feb Living in a monetary union may help fulfill the OCA criteria over time Would the US be an OCA without a common currency – chicken egg Will the existence of the euro change matters too? History never ends: The endogeneity of OCA criteria

Feb Little evidence that reducing exchange rate volatility increases trade Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot –Estimate from 50% to 100% –The border effect provides similar estimates Will trade deepen?

Feb Argument 1: Intra-industry trade will grow Argument 2: Specialization will increase No firm conclusion so far. Will Diversification grow or decline?

Feb Mobility may not change much, but wages could become less sticky Two views –Virtuous circle: labor market responds to enhanced competition by becoming more flexible –The hardening view: labor markets respond to enhanced competition by increasing protective measures that raise stickiness The jury is still out. EMU and Labor Markets

Feb Transfers: –Currently no support for more taxes to finance transfers Homogeneity of preferences –No presumption that it will chnage soon. Commonality of destiny –No presumption that it will chnage soon. Are other criteria endogenous?

Feb Monetary union is not only about economics The OCA criteria do not send a clear signal –The EU is not a perfect OCA –A monetary union may function, at a cost The OCA criteria tells us where the costs will arise –Labor markets and unemployment –Political tensions in presence of deep asymmetric shocks. In the End