Helsinki University of Technology Department of Industrial Engineering and Management TU International Economics by Hannele Wallenius 7 ECONOMIC AND MONETARY UNION

International Economics Hannele Wallenius 7 ECONOMIC AND MONETARY UNION n 7.1 EMU n 7.2 Optimal Currency Areas n 7.3 Cost of Common Currency

International Economics Hannele Wallenius 7.1 EMU n On January 1, 1999 eleven member countries of EU adopted a common currency, Euro (two years latter one more country joined the EMU) n The birth of the Euro resulted in fixed exchange rates between all EMU member countries n By giving up national currencies they handed over control of their monetary policies to ECB

International Economics Hannele Wallenius How and why did Europe set up its single currency? n War-torn history of Europe is the main contributor for both the market and monetary unification n After the Bretton Woods system’s breakdown (1973) currencies, in principle, floated freely against dollar

International Economics Hannele Wallenius n EU countries, however, progressively tried to narrow the extent to which they let their currencies fluctuate against each other Warner committee (1969) started the drive toward European monetary policy the “snake”, a European informal joint float against dollar European Monetary System (EMS) , a formal network of mutually pegged exchange rates (ERM)

International Economics Hannele Wallenius Two Main Motives for Single Currency: 1.To enhance Europe’s role in the world monetary system. EU countries hoped to defend more effectively their economic interests in the face of an increasingly self-absorbed US 2. To turn the European Union into truly unified market. It was believed that exchange rate uncertainty was a major factor reducing trade within Europe

International Economics Hannele Wallenius To turn the European Union into truly unified market... n free trade in goods n free trade in services n free mobility of capital n free mobility of labor market competition leads to common prices across the union, which leads to optimal allocation of resources increasing welfare and economic growth Building blocks of an integrated competitive market. BUT existence of separate national currencies, often subjects countries to erratic exchange rate changes, causes random price fluctuations which disturb the integration process.

International Economics Hannele Wallenius Why was EMS not enough? 1. Single currency was believed to produce a greater degree of European market integration than fixed exchange rates by removing the threat of EMS currency realignments and eliminating the cost of converting one EMS currency into another

International Economics Hannele Wallenius Why was EMS not enough? continued 2. Some EU leaders feared too large of a dominance of German Bundesbank emphasizing German macroeconomic goals. 3.Given the free capital movements, maintaining fixed exchange rates single currency was the best solution.

International Economics Hannele Wallenius Why was EMS not enough? continued 4.Political stability of Europe single currency seen as a potent symbol of Europe’s desire to place cooperation ahead of the national rivalries that often had led to war in the past

International Economics Hannele Wallenius 7 ECONOMIC AND MONETARY UNION n 7.1 EMU n 7.2 Optimal Currency Areas n 7.3 Cost of Common Currency

International Economics Hannele Wallenius 7.2 Optimum Currency Areas n Theory originally developed by Robert Mundell in 1961 Fixed exchange rates within a region, floating between regions n According to the theory of OCA, fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements

International Economics Hannele Wallenius OCA Criteria n Extent of trade n Similarity of shocks and business cycles n Degree of labor mobility n System of fiscal transfers

International Economics Hannele Wallenius Benefits of a Monetary Union n Elimination of transaction costs of changing one currency into another in inter-country trade n Transparency of prices n Reduced exchange rate uncertainty n Low inflation, standardization of interest rates n Increased policy credibility from the elimination of devaluations

International Economics Hannele Wallenius Costs of a Monetary Union n Loss of national monetary policy n If wage inflexibility and labor immobility  unemployment and inflation n Different labor market structures n Raising (government) revenue through inflation n Switching costs  administrative, legal, hardware  psychological n Wrong fixed rate

International Economics Hannele Wallenius Benefits and Costs of Monetary Integration n Lines B and C represent the benefits and costs of the monetary integration, respectively. E is the point where benefits = costs Costs, Benefits Trade/GDP ratio C B H E E* E* is reached after monetary integration. H* Through time a country’s membership in a common market will expand its openness and lead decreased costs.

International Economics Hannele Wallenius Is the EMU an OCA? n Openness and diversification large trade to GDP ratios intra-EMU trade n Similarity of shocks asymmetric shocks: unification of Germany impact of the collapse of Soviet union

International Economics Hannele Wallenius Is the EMU an OCA? Continued n Labor mobility greatly insufficient ￭ System of fiscal transfers no formal system as of yet

International Economics Hannele Wallenius Possible Convergence within EMU n EMU not an OCA ex ante but maybe ex post OCA criteria are jointly endogenous: If a customs union establishes a single market and progresses to an economic union, its internal trade intensity and interdependence between its members rise and become increasingly correlated with symmetry in business cycles as member countries progressively become more similar ( Frankel and Rose, 1998)

International Economics Hannele Wallenius 7 ECONOMIC AND MONETARY UNION n 7.1 EMU n 7.2 Optimal Currency Areas n 7.3 Cost of Common Currency

International Economics Hannele Wallenius 7.3Cost of a Common Currency: An Illustration  How to cure asymmetric shocks?  Devaluation or revaluation of a currency in EU trade is not possible any more... neither can we determine the quantity of national money in circulation, i.e. we have lost the ability to conduct a national monetary policy

International Economics Hannele Wallenius A Two Country Monetary Union AS f AS g AD f AD g YfYf YgYg PfPf PgPg Finland Germany

International Economics Hannele Wallenius n Let's assume that Euroland consumers shift their preferences away from Finnish-made to German-made products: AD F  ‚ and AD G  n Both countries will face an adjustment problem: 1)Finland is plagued by unemployment and current account deficit. 2)Germany experiences a boom  inflation and current account surplus.

International Economics Hannele Wallenius Cost of a Common Currency continued n Is there a mechanism that leads to an automatic equilibrium without devaluation/revaluation? n YES, if there is: 1) wage flexibility 2) labor mobility

International Economics Hannele Wallenius n Wage flexibility would shift the aggregate supply curves of the countries in opposite directions bringing countries back towards the equilibrium n There would also be second-order effects on aggregate demand: wages and prices in Germany would increase making Finnish products more competitive and so increasing AD in Finland and decreasing AD in Germany

International Economics Hannele Wallenius n Labor mobility would eliminate the need for wage rate changes, instead Finns simply would move to Germany to work! n But if wage flexibility and/or labor mobility are not sufficiently high the adjustment problem will not vanish  Instead now the adjustment to the disequilibrium will take the form of inflation in Germany

International Economics Hannele Wallenius n And if German authorities do care of inflation, they want to resist these inflationary pressures (by restrictive monetary and fiscal policies) n But current account problems will not disappear n Revaluation in Germany or devaluation in Finland would solve this dilemma, but that’s now impossible!

International Economics Hannele Wallenius n Can we solve the dilemma by using some other instruments? In principle, yes: Germany could increase taxes to reduce its aggregate demand and transfer these revenues to Finland where they would be spent to increase Finnish aggregate demand !!!! This would mean federalism in EU…

International Economics Hannele Wallenius 6 Economic Integration29 Game Over! Next: EXAM!! Good luck...