Summary Economics of Monetary Integration (2021/2022)
61 views 2 purchases
Course
Economics of Monetary Integration (HBA50C)
Institution
Katholieke Universiteit Leuven (KU Leuven)
Book
Economics of Monetary Union
Complete summary of the course Economics of Monetary Integration. This course is taught by Professor M. Maes and this summary was written in 2021/2022. (BBA KU Leuven)
Introduction
What a country loses when it enters a Monetary Union
- It loses the ability to conduct a national monetary policy (to deal with asymmetric shocks)
- Inability to stabilize national output in a Monetary Union
- Inability to control national interest rate (+ Level of investment)
- Loss of control leads to vulnerability of national governments to liquidity crises
- Differences in labor market institutions between member states leads to inequality
- Differences in legal systems between member states also leads to inequality (+ Costs)
Monetary Union (MU)
= Set of countries that have abandoned their national currencies to use a common currency,
controlled by one, common Central Bank
1.1 Shifts in Demand
Based on Mundell-Fleming Model
- Robert Mundell (1961): Theory of Optimum Currency Areas
- Assume two countries: France + Germany
- Symmetric shock = Affects all regions/countries in the same manner
- Asymmetric shock = Change in economic conditions that affects different countries in a
different way
In case of a symmetric shock
- Common central bank in MU can deal with these kind of shocks
- Common policy stabilizes both German + French economy
- MU (+ common policy) is now more attractive than different monetary policy
- Better to coordinate policies in case of a symmetric shock
In case of an asymmetric shock
- Permanent shock ( Due to changes in consumer preferences)
- Increase in aggregate demand in Germany
- Decrease in aggregate demand in France
- Common CB of MU can’t deal with this issue ( Conflicting desires of member states)
- Monetary independency is now more attractive compared to MU
- Example: Reunification of East and West Germany in 1989 ( Restrictive monetary policy)
Symmetric shock Asymmetric shock
, MU can be costly, unless there is
1. Wage flexibility
- Unemployment rises in France and decreases nominal wages ( Recession in France)
- Aggregate supply in France shifts downwards ( Labor demand > Labor supply)
- Excess demand for labor in Germany pushes up the nominal wages
- In France, price of output declines and makes products more competitive
- The opposite happens in Germany and makes products less competitive ( More costly)
- This shift in demand is called the automatic adjustment process
2. Labor mobility
- French unemployed move to Germany
- Solves unemployment problems in France and excess demand for labor in Germany
- Very limited in Europe ( Wages are still very rigid)
- Primarily on the level of high skilled worked
When not in a MU
- France applies expansionary monetary policy and reduces interest rate
- This stimulates private investment and net export ( Aggregate demand shifts to the right)
- Germany adopts a restrictive monetary policy and raises interest rate
- This decreases private investment and lowers competitivity of Germany
,1.2 Monetary independence and government budgets
When countries join a MU, it reduces the capacity to finance budget deficits
- Countries have no control over monetary policy ( Controlled by CB)
- National governments can no more guarantee 100% payback of all debts
- Countries become more vulnerable to distrust of investors
UK scenario
- Suppose investors fear default of UK government ( UK government bonds are being sold)
- Supply of bonds increases Price decreases and interest rate increases
- Proceeds of sales are being traded in the forex market Pound depreciates
- UK money stock remains on the same level ( Only price of the currency changes)
- This will not lead to any liquidity problems in the UK
Spanish scenario
- Investors fear default of Spanish government ( Spanish government bonds are sold)
- Interest rate increases (due to larger supply of bonds)
- Proceeds of these sales are reinvested in other Eurozone assets
- Spanish money stock declines + lower liquidity in Spain
- No floating exchange rate to counter this issue ( Value of Euro is fixed for all members)
- Leads to liquidity crisis Spanish government can’t guarantee 100% payback of bonds
- Liquidity crisis can turn into a solvency crisis
1.3 Asymmetric shocks and debt dynamics
- Negative shock in France increases budget deficit in France
- Positive shock in Germany increases budget surplus in Germany
- If markets lose trust in solvency of French government Asymmetric shock is amplified
Investors sell French government bonds
- Causes increase in the interest rate
- Causes liquidity crisis in France
- Lower C + I in France AD moves left
Investors buy German government bonds
- Interest rate declines in Germany
- More C + I in Germany AD moves right
Asymmetric shock is amplified
Shouldn’t interest rates be the same in a MU?
- Yes, for short-term interest rate set by ECB
- Not for interest rates on long-term government bonds
- Long-term government bonds contain a risk premium ( Based on risk of default)
Covid-19 Pandemic also caused an asymmetric shock
, 1.4 Booms and busts in a MU ( Temporary asymmetric shocks)
2 possible scenarios in a MU:
1) Investors remain trust in French government
- Investors are willing to buy extra French bonds
- Interest rate remains unchanged
- Investors buy less German government bonds
- Capital market Stabilizing role
2) Investors lose trust in French government
- Investors sell French government bonds
- Investors buy German government bonds
- Interest rate increases in France and decreases in Germany
- Capital market Destabilizing role
1.5 Monetary and budgetary union
MU’s can be fragile
- Asymmetric shocks Adjustment problems, unless there is wage flexibility/labor mobility
- Adjustment problems are even worse if MU-members have low liquidity/solvency
Costs of a MU can be reduced by
- Unlimited liquidity support for bondholders by the CB ( This is not attainable in practice)
- A budgetary union ( Further financial integration/participation between member states)
Budgetary union
1) Insurance mechanism with ex-post transfers
- Automatic stabilization without a deficit in France or surplus in Germany
- Redistribution of tax revenues on European level “Consumption smoothing”
- Extra tax revenues in Germany are used to finance unemployment expenditures in France
- Moral hazard These transfers reduce competitiveness and create political resistance
- Permanent labor market differences between countries are the result of different labor
market policies and institutions ( Related to design of the labor market)
2) Provides protection against a liquidity crisis
- European centralized government that issues European bonds ( In a budgetary union)
- This eliminates capital movement from one bond market to another
- Eliminates all possible future liquidity crises of member states
- Requires political unification and transfer of power/sovereignty to European level
- Very hard to achieve in practice ( No real political willingness from member states)
MU without a budgetary union is an incomplete MU
- Monetary union + budgetary union Full MU
- USA is a better example of a full MU
1.6 Private insurance systems
- Budgetary union Public insurance scheme (against liquidity crises)
- Capital market union Private insurance scheme (against liquidity crises)
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller alexanderbollen. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $5.98. You're not tied to anything after your purchase.
