1. Chapter 3: The Benefits of a Common Currency
De Grauwe:
Economics of Monetary Union

2. Introduction
The costs of EMU have mostly to do with macroeconomic management
The benefits are mostly microeconomic in nature
i.e. they arise from efficiency gains of a monetary union

3. Sources of benefits Less transactions costs Price transparency
Less uncertainty
Benefits of an international currency
Does monetary union lead to more economic growth?

4. 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)
Full cost reduction only achieved when payments systems are fully integrated
TARGET payment system
New initiatives to create a Single Euro Payments Area (SEPA)

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

6. Will euro increase price transparency in a significant way?
Large price differentials continue to exist
These have to do with
transactions costs at the retail level
and product differentiation
See next tables

9. Eurozone has not increased price convergence
Figure 3.1: Evolution of price dispersion in the Eurozone, 1990–2005
Euro has not changed this
There is no evidence of price convergence
Euro may work indirectly by triggering further market integration in particular sectors, e.g. banking, insurance
Source:Wolszczak-Derlacz (2006)

10. The introduction of the Euro and perceived price increases
A major surprise about the introduction of the Euro is its unpopularity in a number of Southern countries
Especially in Italy, but also in Greece, the introduction of the Euro is associated with massive price increases

11. Possible explanation:
Low budget items, with low price elasticities
Competitive markets make it difficult to raise prices
Introduction of Euro creates signal lowering the cost of collective action

12. Less exchange risk Euro eliminates exchange risk. Two issues:
Does the decline in exchange risk increase welfare?
Does the decline in exchange risk reduce systemic risk?

13. Less exchange risk and welfare
Take individual firm under perfect competition
Price certainty
Price uncertainty P P MC MC F E P3 G B P1 P1 P2 C q q

14. Profits are higher on average when there is price uncertainty
Welfare will then depend on degree of risk aversion
If risk aversion sufficiently high price certainty is preferred by firms
Model has a number of important assumptions:
No adjustment costs
With sufficiently large price declines firms can go bankrupt; model assumes no bankruptcy costs

15. Exchange rate uncertainty and the price mechanism
Large exchange variability reduces the quality of price signals in allocating resources
Example: large overvaluation of dollar in 1980s led to decline of export sector; a decline that turned out to be unnecessary once the dollar declined again
These large real exchange rate cycles lead to large adjustment costs

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

17. 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

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

19. Empirical evidence about monetary union and growth
First generation empirical studies found little relation between exchange rate volatility, trade and investment
Using cross-section evidence Andy Rose recently found strong effect of monetary union on trade:
A monetary union doubles trade among members of union, on average
More recent econometric evidence has reduced these effects to 10%-20%
The link monetary union-trade then has positive effect on per capita income (Frankel and Rose)

20. 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

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

22. Box 5: Fixing exchange rate and systemic risks
Shocks in IS-curve:
Monetary union increases variability of output r LM F rf
ISU IS
ISL yL
y’L
y’U yU y

23. Monetary union reduces variability of output
Shocks in LM-curve
Monetary union reduces variability of output
LML r LM
LMU G rf
ISU IS
ISL yL y yU y