1. Chapter 4: Costs and Benefits Compared
De Grauwe:
Economics of Monetary Union

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

3. 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)

4. 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

5. 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

6. Since the early 1980s the 'monetarist' view has gained adherents, and has changed the view many economists have about the desirability of a monetary union
The popularity of monetarism helps to explain why EMU became a reality in the 1990s

7. 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)

8. Is EMU an optimal currency area?
In order to answer to this question there are different parameters to evaluate:
Intra-EU trade
Degree of rigidities
Degree of asymmetry of shocks

9. Table 4.1: Intra-union exports of EU countries (% of GDP) in 2005
Large differences in openness of EU countries with the rest of the Union
For countries with a small degree of openness (UK and Greece), it is less clear that they belong to an optimal currency area with the rest of the EU
Cost-benefit analysis is likely to show net benefits of being in EMU for Benelux, and small central European countries

10. Asymmetric shocks and labour market flexibility
Not only the degree of labour market flexibility which matters for determining whether a monetary union will be attractive to countries
Also asymmetry in demand and supply shocks matters
There is a link between labour market flexibility and asymmetric shocks in a monetary union

11. Asymmetric shocks and labour market flexibility in monetary unions
Downward sloping OCA-line shows minimum combinations of symmetry and flexibility that countries must have in order for a monetary union to provide more benefits than costs
Countries or regions located below the OCA line do not have enough flexibility given the level of symmetry they face
Countries to the right of the OCA line have a lot of flexibility given the level of symmetry they face
Evidence about how many countries in EU form OCA is not clear-cut
Eurozone
Symmetry
USA
EU-25
OCA
Flexibility

12. How can this be achieved? There are essentially two strategies:
The challenging task for the EU-25 is to move to the other side of the OCA-line, i.e. to make a monetary union less costly
How can this be achieved? There are essentially two strategies:
Reduce the degree of real divergence (political union)
Increase the degree of flexibility of labour markets

13. Case-study
During the early 1980s the industrial world was hit by a severe recession
Two examples:
Michigan in the USA
Belgium in Europe
Both regions are of a comparable size
Unemployment increased significantly more in Michigan and Belgium than in the USA and in Europe, respectively.

14. How did these two regions adjust?
In Michigan: mainly outward migration
In Belgium: mainly real depreciation
This helped to restore competitiveness, and started a process of gradual recovery leading to a significant narrowing of the unemployment differential between Belgium and the EC

15. Case-study suggests that even small countries like Belgium, for which the benefits of being in EMU probably outweigh the costs, have taken some risk
When in the future they will be subject to large shocks they will not have a national monetary and exchange rate instrument to soften the blow
As a result, given the rigidity of their labour markets, the adjustment to such large disturbances is likely to be painful

16. Costs and benefits in the long run
The European Commission view of monetary integration
Upward sloping line (TT) because as trade integration increases the degree of symmetry between the countries involved declines
Downward sloping line (OCA):
Less symmetry makes a monetary union more costly. More integration reduces the costs of a monetary union. Thus a reduction in symmetry must be compensated by more integration to make a monetary union worthwhile (in terms of costs and benefits)
Points on OCA line are minimal combinations of symmetry and integration for which monetary union has zero net gain T
Symmetry
EU-25 T
OCA
Trade integration

17. Costs and benefits in the long run
The pessimistic view of monetary integration T´ T
Symmetry
EU-25 T
OCA T´
Trade integration

18. Two possibilities for the long-term prospects of monetary union:
One is represented by the TT line. In this case, although today the EU-25 may not be an optimum currency area, it will move into the OCA zone over time (right side of OCA)
The second case is represented by the steep T’T’ line. Integration brings us increasingly farther away from the OCA zone. The net gains of a monetary union do not increase fast enough with the degree of integration. Thus, the costs of asymmetry overwhelm all the other benefits a monetary union may have
Second case is implausible

19. Endogeniety of monetary union
A decision by an individual country to join EMU, even if it does not satisfy the OCA criteria, can have a self-fulfilling character
In this case the process of integration is sped up by the very decision to join the monetary union, so that this new country grouping moves faster into the OCA zone
OCA becomes endogenous

20. The challenge of enlargement of EMU
Two challenges
Enlargement poses problems for the 12 present members
Enlargement poses problems for the newcomers

21. Is Euro-25 OCA? Openness as a criterion
Figure 4.11: Exports of goods and services towards EU-25 as percentage of GDP (2005)

22. The central European countries are as open towards the EU as the EU-countries themselves
The central European countries appear to be more integrated with the EU than Denmark, Sweden and the UK

23. Is Euro-25 OCA? Asymmetry of shocks
Each point represents correlation between demand and supply shocks of particular country with EU-average
Many CE-countries’ demand shocks negatively correlated with EU demand shocks
Low correlation of supply shocks between CE-countries and EU
Asymmetries in demand shocks may disappear partly in MU, asymmetries in supply shocks more likely to stay

24. Thus, not all CE-countries may be part of an optimal currency area with the rest of the European Union
Despite relatively large openness of the CE-countries vis a vis the EU, many are subjected to relatively large asymmetric shocks, so that it is not obvious that they would gain from entering EMU
However, for some of these countries entering EMU might be the best possible way to import monetary and price stability

25. How will present members be affected by enlargement to Euro-25?
symmetry
Euro-25 more subject to asymmetric shocks than Eurozone
Original members of Eurozone (who are also part of Euro-25) are thrown out of OCA-zone
Some original members will perceive policies of the ECB to be less receptive to their domestic shocks than prior to enlargement
Eurozone
OCA
EU-25
Economic integration

26. Should the UK join EMU? Costs of a monetary union:
Openness: the UK has the lowest degree of openness towards the rest of the EU
Asymmetry of shocks: demand shocks in the UK are negatively correlated with the demand shocks in Euroland
Flexibility: there is greater flexibility in the UK labour markets than in the Eurozone (see the inflation-unemployment of the UK, France and Germany). Thus easier adjustment in UK than in Eurozone
It is unclear whether costs of monetary union are larger in UK than in Eurozone

28. Is Latin America an optimal currency area?
Monetary instability has made the idea of forming a monetary union in Latin America popular
Costs of monetary union in Latin America
Latin American countries have very low levels of trade with the rest of Latin America

29. Figure 4.16: Intraregional exports of goods and services, EU and Latin America as a percentage of GDP (2005)

30. Degree of synchronization of output movements is low in Latin America, and asymmetric shocks are relatively large
Very little empirical evidence has been undertaken to measure the degree of flexibility of labour markets
Main driving force for popularity of MU is the hope to import price stability
If monetary union comes about it will have to provide the right institutions guaranteeing price stability

31. Is East-Asia an optimal currency area?
Source: IMF, IFS and Xu Ning(2004)
Note: the exports of the East-Asian countries is to ASEAN plus China, Korea and Japan. The data for China relate to 2001.

32. Shocks are not more asymmetric in Asia than in Eurozone

33. Economic conditions for monetary union in East Asia seem to be satisfied
Main stumbling block is political
Desire for political unification is weak
Contrast with Europe is great: process of political unification in Europe has been going on since 1960

34. Monetary Unions in Africa
There is a history of monetary union in West- and Central Africa
Legacy of colonization: CFA-zone
New initiative to extend existing monetary unions: The Economic Community of West-African States (ECOWAS)
This is a grouping of 15 states
Do these form an OCA?

35. Figure 4.20: Intraregional exports of goods and services in West-Africa (2003) and the Eurozone (2005)

36. When using the Eurozone as a benchmark, the evidence on whether West Africa forms an optimal currency area is mixed:
The degree of integration among West African countries is low, yielding relatively few benefits of a monetary union
Labour mobility is substantially stronger
The degree of asymmetry does not seem to be larger in West Africa than it is in the Eurozone
West African countries (the members of WAEMU) have already set into place a series of institutions, such as a common central bank facilitating further steps towards a monetary union

37. Conclusion
It is unlikely that the EU as a whole constitutes an optimal monetary union
As integration moves on, the number of countries that are likely to benefit from monetary union will increase
Enlargement of the Eurozone to 25 countries creates serious challenges
Euro-25 is probably not an OCA, but may become one
Enlargement will change the cost benefit calculus of existing members of the Eurozone. Some of these member countries may find out that the enlargement makes the monetary union less attractive

38. It is unlikely that Latin America and East Asia will come to monetary union soon, although reasons are different
Evidence about West-Africa as an OCA is mixed
Our analysis has been based on an economic cost-benefit analysis. Countries may also decide to adopt a common currency for political reasons
The economic cost-benefit analysis remains useful, because it gives an idea of the price some countries will have to pay to achieve these political objectives