Contains a summary of all the chapters of the book Economics of Monetary Union by Paul de Grauwe. This book is used in the course Monetary Policy and Financial Regulation.
Economics of Monetary Union
12th Edition
Paul De Grauwe
SUMMARY
Book information
Author: Paul de Grauwe
Title: Economics of Monetary Union
Year: 2018
ISBN: 978-0-19-880522-9
Chapters: All chapters are covered
,Chapter 1
Shifts in demand
Example: Consumers shift their preferences away from French-made to German-made products.
Looking at the figure 1.1, we see that both countries are not in equilibrium.
2 mechanisms that will bring the countries back in equilibrium
- Wage flexibility:
o Unemployed French workers will reduce their wage claims.
o In Germany the demand for labour will push up the wage rate.
o A new equilibrium occurs (see figure 1.2)
- Mobility of labour:
o French unemployed workers move to Germany.
o This move eliminate the wage decline in France and Germany
When they were not in the EU:
- Exchange rate flexibility.
o France could have lowered their interest rate
o Which stimulates aggregate demand
o Leads to a depreciation of the French franc and leads to an appreciation of the
German mark
o Thereby making the French products sold in Germany cheaper
- Exchange rate pegging.
o France would devalue the franc against the mark
o This increases competitiveness of the French products
o Stimulating the demand coming from Germany.
Symmetric shocks
Example: we now assume that both countries’ demand curves shift to the left.
2
,Now the ECB deals with this:
- Lowers the interest rate which stimulates demand in both countries.
Devaluation not a good option when not in the EU:
- If France devalues this would stimulate demand in France at the expense of Germany.
- French demand curve shifts to the right and Germans demand further to the left.
- France solves their problem by exporting it to Germany.
- Germany would react by depreciation of their currency and a spiral of devaluations and
counter-devaluations would be real.
Avoiding this by coordinating their actions but this is difficult Solution: a monetary union.
Side note:
- this advantage disappears when a asymmetric shock occurs. Read page 7, box 1.1, for more
explanation.
Necessities monetary union to deal with asymmetric shocks in MU:
wage flexibility
mobility of labour
Implications monetary union and budget deficits:
- The entry into a monetary union fundamentally changes the capacity of governments to
finance their budget deficits.
- Members issue debt in a currency over which they have no control.
- They cannot guarantee to the holders of government bonds that they will have enough cash
to pay them out when they mature.
UK Scenario
We assume that investors fear that UK government might be defaulting on its debt:
- They sell their UK bonds which drives up the interest rate
- The investor receive pounds and want to get rid of them on the foreign exchange market
- The price of the pound drops until somebody else is willing to buy these pounds
- The effect is that pounds are invested in UK assets and the pounds remain in the UK.
- In the case that these pounds are not reinvested in UK securities, the government cannot roll
over its debt
- It forces the Bank of England to provide them with cash to pay out the bondholders.
- No default. There is a superior force of last resort.
EU member scenario (Spain):
- Spanish bonds are being sold which drives up the interest rate
- The investors receive euros and are planning to invest them in another country (Germany)
3
, - The euros leave the country and there is no forex market and flexible exchange rate that can
stop this
- Money supply shrinks, liquidity crisis, no funds to roll over its debt.
- Spain cannot control the ECB as it is not its own CB.
How France’s budget deficit increases:
- As a result of the negative demand shock, output and employment decline
- Decline of GDP leads to a decline of government tax receipts
o More than proportional to the decline in GDP because income taxes are progressive
- Government expenditures increases because unemployment increases.
Amplification of asymmetric shocks (see figure 1.5)
France:
- Decline in aggregate demand is so strong that the French government budget deficit
becomes so large that investors start to having doubts about the solvency of the French
government.
- Investors will sell French bonds, leading in turn to an increase in the interest rate and a
liquidity crisis.
- The aggregate demand curve in France will shift further to the left (from D’f to D’’f), i.e. with
a higher interest rate in France, French residents will spend less on consumption and
investment goods.
Germany:
- After the moment that investors sell their French government bonds, investors acquire euros
that they want to invest.
- They are likely to buy German bond because they trust them more than French bonds.
- The price of German bonds increases which in turn reduces the yield on these bonds.
- The effect of this liquidity flow (out of French bonds into German bonds) is that the interest
rate in Germany declines.
- This will increase aggregate demand.
- The initial positive demand shock is now reinforced by an additional shift in the demand
curve (D’g to D’’g).
Amplification because:
- asymmetric demand shock amplifies the negative effects in France and amplifies the positive
effects in Germany.
4
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