Macroeconomic Institutions and Policies
Module 1 Common currencies
Lecture 1 Economics of a common currency
Hoofdstuk 1
Definition of monetary union
- Common currency
- Common central bank setting one interest rate
Kosten bij een gemeenschappelijke munt:
- A country loses monetary policy instrument (changing the exchange rate is no longer
possible)
- This is costly when asymmetric costs occur
Voordelen aan een gemeenschappelijke munt:
- Wisselkoersonzekerheid in Europa wordt uitgeschakeld
- Geen wisselkosten meer in Europa
Shifts in demand:
Asymmetric shock in demand:
- Decline in aggregate demand in France: laagconjunctuur
- Increase in aggregate demand in Germany: hoogconjunctuur
- Permanent/temporary shock
- Monetary union vs monetary independence
Solutions:
Wage flexibility:
- In France, lower wages, supply shifts downwards
- In Germany, higher wages, supply shifts upwards
Labour mobility:
- Moving from France (unemployment) to Germany where there is excess labor
demand
- Very limited in Europe
- Especially for low-skilled workers
- Main reason: social security systems, culture
→ Costs connected to monetary union, because:
- Wage rigidity
- Labor immobility
Nu kunnen Frankrijk en Duitsland hun rentes via monetair beleid niet aanpassen, waardoor
ze wellicht langer in een recessie/boom blijven. Doordat ze samen in een monetaire unie
zitten hebben ze geen autonoom monetair beleid meer (devaluatie/appreciatie), waardoor
een monetaire unie ze langer in een recessie kan houden.
- When countries join a monetary union, they lose their monetary independence
- That affects their capacity to deal with asymmetric shocks
1
, - The loss of monetary independence has another major implication:
- It fundamentally changes the capacity of governments to finance their budget
deficits
Soorten shocks:
Asymmetrisch = verschillende shocks per land
Symmetrisch = covid shock → dezelfde effecten
Members of a monetary union issue debt in currency over which they have no control. It
follows that financial markets acquire power to force default on these countries. Not so in
countries that are not part of monetary union, and have kept over the currency in which they
issue debt. Consider the UK 'stand-alone’ case and that of Italy (member monetary
union).
- UK: Investeerders zijn bang voor een default van de UK: beleggers verkopen
obligaties → koers naar beneden → rente omhoog → pensioenfondsen onder druk
omdat dekkingsgraden onderuit gaan + solvency problem → Bank of England kan
onbeperkt steun geven, dus kan meer geld creëren. Die kunnen gewoon onbeperkt
geld scheppen. Investeerders weten dit, dus zullen ze geen bankruptcy forceren.
- Crisis Italië: Bank in Italië kan niet interveniëren, moet via Frankfurt met alle
Euro-landen in overleg. De Italiaanse bank kan geen Italiaanse obligaties opkopen,
dus is er een liquiditeitscrisis mogelijk → Italië kan geforceerd worden tot default,
Investeerders weten dit, dus zullen dit proberen.
Mario Draghi namens ECB: “We will do whatever it takes to preserve the Euro and believe
me, it will be enough”, 200 miljard of 500 miljard maakt niet uit. Ze kunnen dat gewoon
creëren.
- Daarna gingen aandelenkoersen razendsnel omhoog
- Belang van vertrouwen
Monetary union is fragile
- When investors distrust a particular member government:
- They will sell bonds, then the interest rate increase, and triggering a liquidity
crisis and pension funds will be under pressure and may lead to:
- Solvency problems (less likely to pay back its debt), so long term ipv short term
- With a higher interest rate, the government debt burden increases
- Forcing the government to reduce spending and increase taxation
- Such a forced budgetary austerity is politically costly, and may lead the government
to:
- Stop servicing the debt
- And to declare a default
- By entering a monetary union:
- Member countries become vulnerable to movements of distrust by investors
Institutional differences in labor markets
- Institutional differences in the labor market may lead to divergent wage and
employment tendencies and severe adjustment problems when the exchange rate
instrument has disappeared (--> see H7)
Self-fulfilling prophecy
2
, - When financial markets start distrusting a particular government’s ability to service its
debt:
- Investors will sell the government bonds → more likely that the government
will actually stop servicing the debt
- This dynamic is absent in countries that have kept their monetary independence
- These stand-alone countries issue their debt in their own currencies
- They can always create the liquidity to pay out the bondholders
- This does not mean that these countries may not have problems of their own
- One problem could be that the capacity to finance debt by money creation too
easily leads to inflation
- But it remains true that these countries cannot be forced against their will into default
by financial markets
- The fact that this is possible in a monetary union makes such a union fragile and
costly
1.3 Asymmetric shocks and debt dynamics
- There is an important interaction between asymmetric shocks and debt dynamics:
- Negative shock in France increases budget deficit in France (due to
automatic stabilizers)
- Less income from taxes (more than proportional due to progressive
tax system)
- Because unemployment increases, the French expenditures increase
(social welfare system)
- If financial markets maintain trust in the French government’s solvency, same
analysis as before
- If markets lose trust in the French government then asymmetric shock is
amplified in France and in Germany
- France's demand curve goes further to the left because investors will
sell French government bonds, leading to an increase in the interest
rate and a liquidity crisis. AD shifts further to the left
- With lower interest rate, less investments
- Investors in France will now invest in Germany → Germany demand
curve further to the right (interest rate declines -> increase AD)
Note on diverging interest rates in monetary union (MU)
- Should the interest be the same in a monetary union?
- Yes, for short-term interest rate (otherwise arbitrage): this is the interest rate
the common central bank sets for the whole union
- No for long-term government bond rates
- These diverge if investors attach different risks of holding the different
government bonds (Germany vs Italy)
- It is also the long-term interest rate that affects the AD-curve
Covid-19 shock in 2020: asymmetric effects of a symmetric shock
- Covid-19 hits all countries at the same time. appears to be symmetric shock
- However, its effects on EMU-countries were very asymmetric
- Large differences in effect on GDP
- Therefore, also large differences in effects on budget deficits and debts
3
, - Landen kunnen zich minder permitteren als je al een hoge staatsschuld hebt
dan landen die een buffer hebben.
- Grote verschillen in uitgangspositie werkt dus door
- Potential for renewed sovereign debt crisis was created
- And avoided
1.4 Monetary union and budgetary union
- This consists of centralizing a significant part of the national budgets into a common
union budget
- This is a monetary union with a budgetary union
- Such a budgetary union achieves two things:
1) Creates insurance mechanism triggering income transfers from the country
experiencing good times to the countries hit by bad luck
a) Allows for automatic transfers between countries of monetary union:
i) Can offset monetary shocks
ii) Is largely absent at European level
iii) Exists at national level
iv) Creates problems of moral hazard
2) Consolidation of national government debts and deficits, thereby protecting its
members from liquidity crises and forced defaults
A budgetary union as a protection mechanism
- A budgetary union creates a union government capable of forcing common central
bank into providing liquidity in moments of crisis
- The union government acquires the characteristics of a ‘stand-alone’ government (it
issues debt in a currency over which it has full control)
- The union government cannot be confronted with a liquidity crisis (at least if the union
maintains a flexible exchange rate with the RotW)
Is there any prospect that Europe could move into such a budgetary union?
- Not really
Hoofdstuk 2 The theory of optimum currency areas
Does integration lead to more/less asymmetric shocks?
- Optimistic view (European Commissie): Integration → symmetry
- Intra-industry trade leads to similar specialization patterns → symmetry
- Integration leads to more equal economic structures and less asymmetric
shock
- Trade between the industrial European nations is to a large degree
intra-industry trade. The trade is based on the existence of economies of
scale and imperfect competition. It leads to a structure of trade in which
countries buy and sell to each other the same categories of products.
Demand shocks will affect these countries in a similar way
- Pessimistic view (Krugman): integration → asymmetry
- Economies of scale lead to agglomeration effects and clustering
- Integration leads to more asymmetric shocks
4
Module 1 Common currencies
Lecture 1 Economics of a common currency
Hoofdstuk 1
Definition of monetary union
- Common currency
- Common central bank setting one interest rate
Kosten bij een gemeenschappelijke munt:
- A country loses monetary policy instrument (changing the exchange rate is no longer
possible)
- This is costly when asymmetric costs occur
Voordelen aan een gemeenschappelijke munt:
- Wisselkoersonzekerheid in Europa wordt uitgeschakeld
- Geen wisselkosten meer in Europa
Shifts in demand:
Asymmetric shock in demand:
- Decline in aggregate demand in France: laagconjunctuur
- Increase in aggregate demand in Germany: hoogconjunctuur
- Permanent/temporary shock
- Monetary union vs monetary independence
Solutions:
Wage flexibility:
- In France, lower wages, supply shifts downwards
- In Germany, higher wages, supply shifts upwards
Labour mobility:
- Moving from France (unemployment) to Germany where there is excess labor
demand
- Very limited in Europe
- Especially for low-skilled workers
- Main reason: social security systems, culture
→ Costs connected to monetary union, because:
- Wage rigidity
- Labor immobility
Nu kunnen Frankrijk en Duitsland hun rentes via monetair beleid niet aanpassen, waardoor
ze wellicht langer in een recessie/boom blijven. Doordat ze samen in een monetaire unie
zitten hebben ze geen autonoom monetair beleid meer (devaluatie/appreciatie), waardoor
een monetaire unie ze langer in een recessie kan houden.
- When countries join a monetary union, they lose their monetary independence
- That affects their capacity to deal with asymmetric shocks
1
, - The loss of monetary independence has another major implication:
- It fundamentally changes the capacity of governments to finance their budget
deficits
Soorten shocks:
Asymmetrisch = verschillende shocks per land
Symmetrisch = covid shock → dezelfde effecten
Members of a monetary union issue debt in currency over which they have no control. It
follows that financial markets acquire power to force default on these countries. Not so in
countries that are not part of monetary union, and have kept over the currency in which they
issue debt. Consider the UK 'stand-alone’ case and that of Italy (member monetary
union).
- UK: Investeerders zijn bang voor een default van de UK: beleggers verkopen
obligaties → koers naar beneden → rente omhoog → pensioenfondsen onder druk
omdat dekkingsgraden onderuit gaan + solvency problem → Bank of England kan
onbeperkt steun geven, dus kan meer geld creëren. Die kunnen gewoon onbeperkt
geld scheppen. Investeerders weten dit, dus zullen ze geen bankruptcy forceren.
- Crisis Italië: Bank in Italië kan niet interveniëren, moet via Frankfurt met alle
Euro-landen in overleg. De Italiaanse bank kan geen Italiaanse obligaties opkopen,
dus is er een liquiditeitscrisis mogelijk → Italië kan geforceerd worden tot default,
Investeerders weten dit, dus zullen dit proberen.
Mario Draghi namens ECB: “We will do whatever it takes to preserve the Euro and believe
me, it will be enough”, 200 miljard of 500 miljard maakt niet uit. Ze kunnen dat gewoon
creëren.
- Daarna gingen aandelenkoersen razendsnel omhoog
- Belang van vertrouwen
Monetary union is fragile
- When investors distrust a particular member government:
- They will sell bonds, then the interest rate increase, and triggering a liquidity
crisis and pension funds will be under pressure and may lead to:
- Solvency problems (less likely to pay back its debt), so long term ipv short term
- With a higher interest rate, the government debt burden increases
- Forcing the government to reduce spending and increase taxation
- Such a forced budgetary austerity is politically costly, and may lead the government
to:
- Stop servicing the debt
- And to declare a default
- By entering a monetary union:
- Member countries become vulnerable to movements of distrust by investors
Institutional differences in labor markets
- Institutional differences in the labor market may lead to divergent wage and
employment tendencies and severe adjustment problems when the exchange rate
instrument has disappeared (--> see H7)
Self-fulfilling prophecy
2
, - When financial markets start distrusting a particular government’s ability to service its
debt:
- Investors will sell the government bonds → more likely that the government
will actually stop servicing the debt
- This dynamic is absent in countries that have kept their monetary independence
- These stand-alone countries issue their debt in their own currencies
- They can always create the liquidity to pay out the bondholders
- This does not mean that these countries may not have problems of their own
- One problem could be that the capacity to finance debt by money creation too
easily leads to inflation
- But it remains true that these countries cannot be forced against their will into default
by financial markets
- The fact that this is possible in a monetary union makes such a union fragile and
costly
1.3 Asymmetric shocks and debt dynamics
- There is an important interaction between asymmetric shocks and debt dynamics:
- Negative shock in France increases budget deficit in France (due to
automatic stabilizers)
- Less income from taxes (more than proportional due to progressive
tax system)
- Because unemployment increases, the French expenditures increase
(social welfare system)
- If financial markets maintain trust in the French government’s solvency, same
analysis as before
- If markets lose trust in the French government then asymmetric shock is
amplified in France and in Germany
- France's demand curve goes further to the left because investors will
sell French government bonds, leading to an increase in the interest
rate and a liquidity crisis. AD shifts further to the left
- With lower interest rate, less investments
- Investors in France will now invest in Germany → Germany demand
curve further to the right (interest rate declines -> increase AD)
Note on diverging interest rates in monetary union (MU)
- Should the interest be the same in a monetary union?
- Yes, for short-term interest rate (otherwise arbitrage): this is the interest rate
the common central bank sets for the whole union
- No for long-term government bond rates
- These diverge if investors attach different risks of holding the different
government bonds (Germany vs Italy)
- It is also the long-term interest rate that affects the AD-curve
Covid-19 shock in 2020: asymmetric effects of a symmetric shock
- Covid-19 hits all countries at the same time. appears to be symmetric shock
- However, its effects on EMU-countries were very asymmetric
- Large differences in effect on GDP
- Therefore, also large differences in effects on budget deficits and debts
3
, - Landen kunnen zich minder permitteren als je al een hoge staatsschuld hebt
dan landen die een buffer hebben.
- Grote verschillen in uitgangspositie werkt dus door
- Potential for renewed sovereign debt crisis was created
- And avoided
1.4 Monetary union and budgetary union
- This consists of centralizing a significant part of the national budgets into a common
union budget
- This is a monetary union with a budgetary union
- Such a budgetary union achieves two things:
1) Creates insurance mechanism triggering income transfers from the country
experiencing good times to the countries hit by bad luck
a) Allows for automatic transfers between countries of monetary union:
i) Can offset monetary shocks
ii) Is largely absent at European level
iii) Exists at national level
iv) Creates problems of moral hazard
2) Consolidation of national government debts and deficits, thereby protecting its
members from liquidity crises and forced defaults
A budgetary union as a protection mechanism
- A budgetary union creates a union government capable of forcing common central
bank into providing liquidity in moments of crisis
- The union government acquires the characteristics of a ‘stand-alone’ government (it
issues debt in a currency over which it has full control)
- The union government cannot be confronted with a liquidity crisis (at least if the union
maintains a flexible exchange rate with the RotW)
Is there any prospect that Europe could move into such a budgetary union?
- Not really
Hoofdstuk 2 The theory of optimum currency areas
Does integration lead to more/less asymmetric shocks?
- Optimistic view (European Commissie): Integration → symmetry
- Intra-industry trade leads to similar specialization patterns → symmetry
- Integration leads to more equal economic structures and less asymmetric
shock
- Trade between the industrial European nations is to a large degree
intra-industry trade. The trade is based on the existence of economies of
scale and imperfect competition. It leads to a structure of trade in which
countries buy and sell to each other the same categories of products.
Demand shocks will affect these countries in a similar way
- Pessimistic view (Krugman): integration → asymmetry
- Economies of scale lead to agglomeration effects and clustering
- Integration leads to more asymmetric shocks
4
