This is an English summary of chapter from the book: The Essentials of Economics of Krugman & Wells and The Economics of European Integration by Baldwin & Wyplosz. The chapters included are the required readings from week 4 to7 of the course European Economics II: Macro 2018/2019 for the final exam...
BW Chapter 15
The question, the problem and the short answer
Currency is symbol of statehood.
Money’s key feature is to avoid achieving the ‘double coincidence of wants’:
barter. With money you can buy what you want without needing to sell
something else. money makes commercial and fnancial transactions much
easier than barter and is immediately recognizable.
World would beneft from having just one currency: no need to exchange money
when traveling, importing, exporting. Exchanging currency is costly and
currency transactions are risky as exchange rates fuctuate. This is why small
currency areas: geographic zones that share the same currency, are clearly not
optimal. A currency that is used in small area is not very useful.
Marginal beneft curve represents this idea. It measures the added advantage of
increasing currency area by one unit. Usefulness of currency grows with the size
of the area within which it is being used, its marginal beneft is positive. It is
declining as the area expanse because the extra beneft from adding one more
country to already large currency area is smaller than when initial area was
small.
As currency area grows larger it becomes more diverse. More diversity means
more costs when sharing common currency, marginal costs are positive and
rising with size of area. That is why marginal cost are upward sloping.
There is a trade-of: large currency area is desirable because enhances
usefulness of money but has drawbacks. Optimal currency area corresponds
where marginal costs and benefts from sharing same currency balance each
other out.
Benefts of currency area
With creation of euro there were no transaction costs of exchanging currency
anymore. more competition.
Another beneft is that goods prices become directly comparable across
countries that are part of monetary union. more competition. beneft
consumers and encourage producers to keep improving their oferings.
Transparency and competition also afect wage setting. Wages are set
collectively. Natural for trade unions to seek wage increases. If increases are
too large frms lose their competitiveness. Workers in diference countries
compete against each other via exports. When exchange rate can be changed
the tendency is to raise wages and then prices and then to depreciate exchange
rate to recover competitiveness. One source of rampant infation but not
,eficient one since depreciation raises price of imports, along with higher
domestic prices result is purchasing power of wages declines wage increases.
Another beneft: brining more economic logic to setting wages. Requires deep
changes in process that is politically and socially complex. Efect is likely to take
long time.
Another beneft: elimination of exchange rate risk. When exports are priced in
currency of exporter the importer does not know precisely what the exchange
rate will be when the time comes to settle purchase. The party facing the risk
may purchase fnancial insurance which adds cost of converting currencies.
With easier and more secure payments and more competition a common
currency encourage more trade. Benefts all citizens in many ways. Provides
more choice for customers and more customers for successful producers. More
intense competition is bound to cut prices of producers how enjoy some degree
of monopoly on their home turf. Common currency eliminate some non-tarif
barriers.
Joining monetary union implies complete loss of national monetary policy
autonomy.
Central banking theory has implications under fexible exchange rate regime:
- CB is solely responsible for infation. ong run price stability must be key
objective of monetary policy
- Monetary policy can be used to smooth cyclical fuctuations. In short run
the CB should adjust its interest rate accordingly.
- Short and long term objectives can occasionally confict with each other.
Solution is for the CB to fexible in the short term and to set interest rate
without undue concern for the evolution of money stock in long term it
must be determined to keep money stock growth rate in line with infation
objective.
- Balancing act between short and long run imperatives can be delicate and
confusing. First risk is that monetary policy can be misunderstood. Firms
and households may then set prices and wages that are incompatible with
objectives of monetary policy. Second risk is fnancial markets may
destabilize exchange rate. Response for CB to develop clear strategy and
to be transparent regarding implementation of strategy.
Important consideration concerns the relation between CBs and their
governments. Resulting seignior age profts are turned to the government for
which it represents a sizeable source of income. Seigniorage is a form of
taxation as long as infation remains low. Result of seigniorage is often high
infation.
Good monetary policy requires full CB independence along with clear monetary
policy strategy and high degree of transparency.
CB independence achieved through adequate domestic governance.
Beneft of monetary union is that collective CB is more likely to extract itself
from government pressure because no government will want to see the common
monetary policy used to fnance other governments. CB independence
guaranteed by international agreement is less likely to be revoked. Mission of
common CB is defned trough explicit agreement which is likely to be better
formulated than often implicit and vague mission statements.
Cost of a currency area
,Diversity in currency area is costly because a common currency requires a
single central bank and a single monetary authority is unable to react to each
and every local particularity.
The optimum currency area OCA aims at identifying these costs more precisely.
Basic idea is that diversity translates into asymmetric shocks and that exchange
rate is useful in dealing with these shocks.
3 steps:
1. Defne and examine efects of asymmetric shocks
2. Study problems that arise in presence of asymmetric shocks in currency
area
3. Ask how the efects of asymmetric shocks can be mitigated when national
exchange rates are no longer available.
To re-establish a hole in the balance of trade the country needs to make its
exports cheaper. This calls for enhanced competitiveness.
One solution would be for prices and wages to decline. If they don’t a
depreciation will do it if country has its own currency. But if country is part of
wider currency area there is no alternative to lowering prices.
Diversity means that diferent countries face diferent shocks. If countries A and
B are hit by same adverse shock both undergo a real depreciation vis a vis the
rest of the world. If they are similar enough there is no need for their bilateral
exchange rate to change. They’re in the same boat facing the same headwinds.
This shows that loss of exchange rate within currency union is of no
consequence as long as all member countries face the same shocks. Union
simply adjusts its common exchange rate vis a vis the rest of the world and its
member countries are as well of as if they had each independently changed
their own exchange rate.
Situation is diferent when there’s a asymmetric shock. When country A gets
asymmetric shock but B not. A can’t change exchange rate because they can’t
have diferent nominal exchange rates. The common CB must make a choice on
their behalf.
If union’s common external exchange rate foats freely, it will depreciate
because of the adverse shock in one part of the area but not all the way. The
outcome is a combination of excess supply in country A and excess demand in
Country B. both countries are in disequilibrium. New exchange rate is correct
on average but is too strong for A and too weak for B.
No good outcome is fundamental and unavoidable cost of forming monetary
union.
Over time prices are fexible and will do what they are expected to do.
There can also be asymmetric efects because countries don’t react the same
way to same shock. Because of diferent socio economic structures.
When common CB reacts to symmetric shock it is not concluded that efect of its
action will be the same in whole currency union. Diferences in structure of
banking and fnancial markets or in size of frms may result in asymmetric
efects.
The optimum currency area criteria
OCA is contradiction for 2 reasons. First because the theory doesn’t really deal
with optimality as it simply balances costs and benefts. Second, theory doesn’t
provide yeas or no answers. It derives criteria that make common currency
acceptable.
3 classic economic criteria and 3 political criteria.
,Frist criterion asks what characteristics make it easier to deal with asymmetric
shocks within currency area. Next two economic criteria take diferent
approach: aim to identify which economic areas are less likely to be hit by
asymmetric shocks or to face shocks moderate enough to be of limited concerns.
ast three criteria deal with political aspects; ask whether diferent countries
are likely to help each other when faced with asymmetric shock.
Frist criterion proposed by Robert Mundell. Idea is that cost of sharing same
currency would be eliminated if factors of production capital and labour were
fully mobile across borders.
Mundell criterion:
OCAs are those within which people move easily.
Why should unemployment rise in some part of currency area while in other
parts frms can’t produce enough to satisfy demand, people and their equipment
should move.
But not so simple. Common culture and language etc. make labour mobility
easier within a country that across borders. National currency is not just symbol
of statehood it is justifed by labour mobility. Response is to change legislation
to make cross border labour mobility easier and enlarge see of OCAs.
Criticism: Goods produced in country A may difer from those produced in
country B. takes time to retrain workers from A to produce goods of B.
abour needs equipment to be productive. What it is already used in B?
Asymmetric shocks are problem within currency area. But they happen rarely.
Countries most likely to be afected by sever shocks are those that specialize in
production of narrow range of goods.
Kenen criterion
Countries whose production and exports are widely diversifed and of similar
production structure form an OCA.
Criticism: very broad statement.
Next question is whether exchange rate is at all helpful in presence of
asymmetric shock. If not little is lost by giving it up. Distinction between
domestic and foreign goods refers to where the goods are produced and priced.
However many standards goods although produced in diferent countries are
identical. Trade competition will ensure that their prices are the same
everywhere and therefore largely independent of exchange rate. Modern trade
takes form of value chains whereby fnished products incorporate many parts
produced all over the world.
McKinnon criterion
Countries that are very open to trade and trade heavily with each other form an
OCA. When A and B don’t share same currency they have their own exchange
rate vis a vis rest of world. If they’re open and trade intensively with each other
the distinction between domestic and foreign goods loses mush signifcance as
competition will equalize prices of most goods when expressed in same
currency.
Criticism: exchange rate doesn’t afect competiveness in sense that competition
forces prices to be the same.
,Transfer criterion
Countries that agree to compensate each other for adverse shocks form an OCA.
Transfer schemes of this kind exist across region in every country.
Criticism: debt crisis has brought forward issue of transfers. Seen as form of
insurance against asymmetric shocks. If it’s always same countries that sufer
from adverse shocks the other countries might see it as a costly undertaking .
countries may take fewer precautions to ovoid frequent shocks if they expect
transfers.
Homogeneity of preferences criterion
Currency union member countries must reach consensus on the best way to deal
with shocks.
Criticism: very broad statement. Within country political parties usually disagree
on policies and oficial view changes when power changes hand. Criterion must
refer to shared values that are not the same form one country to another.
Solidarity criterion
When common monetary policy gives rise to conficts of national interest, the
countries that form a currency area need to accept the costs in the name of a
common destiny.
Criticism: currency union is not free ride and costs are bound to arise now and
then when there are asymmetric shock. When benefts are too difuse to be fully
felt solidarity becomes essential. Political union is asserted creates the
necessary sense of solidarity. A deeper question is whether this sense of
solidarity can only be the outcome of political union.
Endogenous criteria?
Characteristics of a country may change over time. Can an area that is not a
OCA become one as a consequence of being one?
This possibility is called the endogeneity of the OCA criteria.
Following sections describe the possible efects of an asymmetric shock when
the 6 criteria are not fully satisfed:
- Labour mobility: when country A has high level of unemployment and B
face labour shortages, the incentive for citizens to move becomes more
urges. A shock may therefore encourage labour mobility in situations
where exchange rate adjustments made it previously unnecessary.
- Diversification: high degree of specialization implies that some countries
will be hard hit when they are afected by specifc shocks. Consequence
many frms will disappear. Displaced managers and employees will seek
other ways of gaining giving. Form new frms in new lines of business,
which will reduce extent of specialization.
- Openness: evolution of trade towards value chains is making this criterion
less relevant. This isn’t endogeneity because the changes occur not as
response to presence of monetary union but to technological changes.
- Homogeneous preferences: within currency area transparency is beneft
because it enhances competition. Makes comparisons easier and more
convincing. Shocks reveal underlying weaknesses and they may trigger
Darwinian responses.
- Transfers: insurance may merely be convenient but in most countries is
justifed by either r of two issues. Firs is solidary which is related to
, common destiny criterion; second common interest: when one country
sufers from shock and sees its GDP decline, imports from other countries
are reduced and thus shock spreads. Reducing efect is therefore e in
every country’s interests.
- Common destiny: people who share same currency feel closer to each
other. Greater interdependence is seen as threat because one country’s
troubles can be costly to the others.
Is Europe an OCA?
Most European countries do well on openness and diversifcation two of the
three classic economic OCA criteria.
CRITERION SATISFIED?
Labour mobility NO
Trade openness YES
Product diversifcation YES
Fiscal transfers NO
Homogeneity of preferences PART Y
Commonality of destiny ?
KW: Chapter 17
Fiscal policy: the basics
Social insurance: programs are government programs intended to protect
families against economic hardship.
GDP = C + I + G + (X – M)
Sum of consumer spending, investment spending, government purchases of
goods and services, and value of exports minus value of imports. Includes all
sources of aggregate demand.
Government can infuence G but also through changes in taxes and transfers
consumer spending C and sometimes investment spending I.
An increase in taxes or reduction in government transfers reduces disposable
income. fall consumer spending.
Decrease in taxes or increase in government transfers increases disposable
income. rise in consumer spending.
Government can use changes in taxes or government spending to shift the
aggregate demand curve.
Fiscal policy: use of taxes, government transfers, or government purchases of
goods and services to stabilize economy by shifting the aggregate demand
curve.
Government want to shift the aggregate demand curve because it wants to close
either a recessionary gap, created when aggregate output falls below potential
output or an infationary gap, created when aggregate output exceeds potential
output.
In initial short run equilibrium, E, aggregate output is Y, below potential output
Pym. Government would like to do is increase aggregate demand, shifting the
aggregate demand curve rightward to AD. Would increase aggregate output,
making it equal to potential output. Fiscal policy that increases aggregate
demand = expansionary fscal policyy.
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