Lecture 8: Optimum Currency Areas European Economic Issues © Baldwin & Wyplosz 2003 Reading: Sloman Chapter 25 Baldwin & Wyplosz Ch12 Swann Chapter 7.

Lecture 8: Optimum Currency Areas

European Economic Issues

© Baldwin & Wyplosz 2003

Reading: Sloman Chapter 25

Baldwin & Wyplosz Ch12

Swann Chapter 7

A Good Question, No Simple AnswerA Good Question, No Simple Answer

• Should currency area borders coincide with national borders?Should currency area borders coincide with national borders?– is it a good idea for California to be on the US dollar?is it a good idea for California to be on the US dollar?

A Good Question, No Simple AnswerA Good Question, No Simple Answer

• Should currency area borders coincide with national borders?Should currency area borders coincide with national borders?– is it a good idea for California to be on the US dollar?is it a good idea for California to be on the US dollar?

Source: Baldwin and Wyplosz

A Good Question, No Simple AnswerA Good Question, No Simple Answer

• Should currency area borders coincide Should currency area borders coincide with national borders?with national borders?

• If not, how best to delineate currency If not, how best to delineate currency areas?areas?

• What economic criteria should be used?What economic criteria should be used?

In a NutshellIn a Nutshell• The benefits:The benefits:– money exhibits increasing returns to scale money exhibits increasing returns to scale

(network externalities)(network externalities)– the world is the way to maximize these benefits.the world is the way to maximize these benefits.– One money reduces nominal uncertaintyOne money reduces nominal uncertainty– One money eliminates trade distortionsOne money eliminates trade distortions

• The costs:The costs:– loss of monetary and exchange rate instrumentsloss of monetary and exchange rate instruments

matters matters (only)(only) in presence of: in presence of:

– price and wage stickiness

– asymmetric shocks.

Focusing on CostsFocusing on Costs

• Start with the idea that benefits argue for one Start with the idea that benefits argue for one worldwide currency.worldwide currency.

• Ask why not.Ask why not.• Why would we need individual monetary policy?Why would we need individual monetary policy?• Asymmetric shocks or shocks that affect us Asymmetric shocks or shocks that affect us

asymmetricallyasymmetrically

• E.g Coffee prices E.g Coffee prices (? D or S shock?)(? D or S shock?)• Oil Prices Oil Prices (? D or S shock?)(? D or S shock?)• Different intuitional settings such as home-Different intuitional settings such as home-

ownership or labour lawownership or labour law (Maybe)(Maybe)

Focusing on CostsFocusing on Costs

• So if have asymmetric shocks might So if have asymmetric shocks might want to react differentlywant to react differently

• But Fiscal Policy or Monetary PolicyBut Fiscal Policy or Monetary Policy

• And if Monetary Policy–does it workAnd if Monetary Policy–does it work

• Do changes in exchange rates Do changes in exchange rates influence REAL economy –for good?influence REAL economy –for good?

• Answer to these questions determines Answer to these questions determines viewsviews

Implications of Asymmetric Shocks and Effective Implications of Asymmetric Shocks and Effective Monetary PolicyMonetary Policy

• IFF believe that monetary policy can IFF believe that monetary policy can positively influence real variables positively influence real variables

• (By that we mean that we know precisely (By that we mean that we know precisely what will happen when we make policy what will happen when we make policy changes not that something will happen but changes not that something will happen but we are not very sure what we are not very sure what ex anteex ante) )

• THEN may want to divide world up into THEN may want to divide world up into suitable currency areas.suitable currency areas.

• The analysis develops six OCA criteria.The analysis develops six OCA criteria.

Criterion 1 (Mundell): Labour MobilityCriterion 1 (Mundell): Labour Mobility

• In an OCA labour moves easily across In an OCA labour moves easily across national borders.national borders.

• Caveats:Caveats:– labour mobility is easy within national labour mobility is easy within national

borders (culture, language, legislation, borders (culture, language, legislation, welfare, etc.)welfare, etc.)

– capital mobility: difference between capital mobility: difference between financial and physical capitalfinancial and physical capital

– in presence of country specialization, in presence of country specialization, skills also matter.skills also matter.

Criterion 2 (Kenen): Production DiversificationCriterion 2 (Kenen): Production Diversification

• Countries whose production and exports Countries whose production and exports are widely diversified and of similar are widely diversified and of similar structure form an OCA.structure form an OCA.

• Indeed, in that case, there are few Indeed, in that case, there are few asymmetric shocks and each of them is asymmetric shocks and each of them is likely to be of small concern.likely to be of small concern.

Criterion 3 (McKinnon): OpennessCriterion 3 (McKinnon): Openness

• Countries which are very open to trade and trade Countries which are very open to trade and trade heavily with each other form an OCA.heavily with each other form an OCA.

• Distinguish between traded and nontraded Distinguish between traded and nontraded goods:goods:– traded good prices are set worldwidetraded good prices are set worldwide– a small economy is price-taker, so the a small economy is price-taker, so the

exchange rate does not affect competitiveness.exchange rate does not affect competitiveness.• In the limit, if all goods are traded, domestic good In the limit, if all goods are traded, domestic good

prices must be flexible and the exchange rate prices must be flexible and the exchange rate does not matter for competitiveness. does not matter for competitiveness. (But matters (But matters for what you get for your exports)for what you get for your exports)

Criterion 4: Fiscal TransfersCriterion 4: Fiscal Transfers

• Countries that agree to compensate each Countries that agree to compensate each other for adverse shock form an OCA.other for adverse shock form an OCA.

• Transfers can act as an insurance that Transfers can act as an insurance that mitigates the costs of an asymmetric mitigates the costs of an asymmetric shock.shock.

• Transfers exist within national borders:Transfers exist within national borders:– implicitly through the welfare systemimplicitly through the welfare system– explicitly in federal states.explicitly in federal states.

Criterion 5: Homogeneous PreferencesCriterion 5: Homogeneous Preferences

• Countries that share a wide consensus on Countries that share a wide consensus on the way to deal with shocks form an OCA.the way to deal with shocks form an OCA.

• Matters primarily for symmetric shocks:Matters primarily for symmetric shocks:– prevalent when the Kenen criterion is prevalent when the Kenen criterion is

satisfied.satisfied.• May also help for asymmetric shocks:May also help for asymmetric shocks:

– better understanding of partners’ actionsbetter understanding of partners’ actions– encourages transfers.encourages transfers.

Criterion 6: Commonality of DestinyCriterion 6: Commonality of Destiny

• Countries that view themselves as sharing Countries that view themselves as sharing a common destiny better accept the costs a common destiny better accept the costs of operating an OCA.of operating an OCA.

• A common currency will always face A common currency will always face occasional asymmetric shocks that result occasional asymmetric shocks that result in temporary conflicts of interests:in temporary conflicts of interests:

– this calls for accepting such economic this calls for accepting such economic costs in the name of a higher purpose.costs in the name of a higher purpose.

Is Europe An OCA?Is Europe An OCA?

• Asymmetric effects of symmetric shocks: effects on GDP and Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate.prices of a change of the common interest rate.

© Baldwin & Wyplosz 2003

Source: Baldwin and Wyplosz

Is Europe An OCA?Is Europe An OCA?

• Asymmetric effects of symmetric shocks: effects on GDP and Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate.prices of a change of the common interest rate.

© Baldwin & Wyplosz 2003

Source: Baldwin and Wyplosz

Inside the OCA Index: OpennessInside the OCA Index: Openness• Most EU countries are very open.Most EU countries are very open.• The McKinnon criterion is broadly satisfied.The McKinnon criterion is broadly satisfied.

© Baldwin & Wyplosz 2003

Source: Baldwin and Wyplosz

Inside the OCA Index: DiversificationInside the OCA Index: Diversification

• Most EU countries Most EU countries have a diversified have a diversified production production structure (intra-structure (intra-industry trade industry trade dominates).dominates).

• The Kenen The Kenen criterion is criterion is broadly satisfied broadly satisfied and well explains and well explains which countries which countries joined the euro joined the euro area.area.

© Baldwin & Wyplosz 2003

Inside the OCA Index: Labour Mobility (1)Inside the OCA Index: Labour Mobility (1)

• The labour mobility criterion cannot be black-The labour mobility criterion cannot be black-and-white.and-white.

• The migration response to economic incentives The migration response to economic incentives must factor in many costs:must factor in many costs:– moving costsmoving costs– risk of becoming unemployedrisk of becoming unemployed– longer run career opportunitieslonger run career opportunities– family prospectsfamily prospects– eligibility to welfareeligibility to welfare– taxationtaxation– cultural/linguistic differencescultural/linguistic differences– national attachment.national attachment.

Inside the OCA Index: Labour Mobility (2)Inside the OCA Index: Labour Mobility (2)

• An international An international comparison suggests comparison suggests that labour mobility that labour mobility is low in Europe:is low in Europe:– across countries.across countries.

© Baldwin & Wyplosz 2003

Inside the OCA Index: Labour Mobility (2)Inside the OCA Index: Labour Mobility (2)

• An international An international comparison comparison suggests that suggests that labour mobility is labour mobility is low in Europe:low in Europe:– across across

countriescountries– even within even within

countriescountries (% moving (% moving

region per region per year).year).

© Baldwin & Wyplosz 2003

Inside the OCA Index: Labour Mobility (3)Inside the OCA Index: Labour Mobility (3)

• Low labour mobility implies that unemployment bears Low labour mobility implies that unemployment bears much of the burden of adjustment to shocks.much of the burden of adjustment to shocks.

• A US-EU comparison.A US-EU comparison.

Inside the OCA Index: Labour Mobility (3)Inside the OCA Index: Labour Mobility (3)

Source: Baldwin and Wyplosz

Inside the OCA Index: TransfersInside the OCA Index: Transfers

• The EU does not satisfy the transfer The EU does not satisfy the transfer criterion.criterion.

• The overall EU budget:The overall EU budget:

– is low, capped at 1.27% of EU GDPis low, capped at 1.27% of EU GDP

– entirely used for administration, CAP, entirely used for administration, CAP, regional and structural funds.regional and structural funds.

Inside the OCA Index: Homogeneity of Inside the OCA Index: Homogeneity of PreferencesPreferences

• Little is known about this criterion.Little is known about this criterion.

Inside the OCA Index: Commonality of DestinyInside the OCA Index: Commonality of Destiny

• Little is known about this criterion.Little is known about this criterion.• Public opinion polls do not detect deep Public opinion polls do not detect deep

opposition to EU institutions.opposition to EU institutions.

Inside the OCA Index: Commonality of DestinyInside the OCA Index: Commonality of Destiny

© Baldwin & Wyplosz 2003

OverallOverall

• The OCA glass is half full, or half empty.The OCA glass is half full, or half empty.

© Baldwin & Wyplosz 2003

History Never Ends: The Endogeneity of OCA History Never Ends: The Endogeneity of OCA CriteriaCriteria

• Living in a monetary union may help Living in a monetary union may help fulfill the OCA criteria over time.fulfill the OCA criteria over time.

• Would the US be an OCA without a Would the US be an OCA without a single common currency?single common currency?

• Will the existence of the euro area Will the existence of the euro area change matters too?change matters too?

Will Trade Deepen?Will Trade Deepen?

• Little evidence that reducing exchange rate Little evidence that reducing exchange rate volatility increases trade.volatility increases trade.

• Mounting evidence that eliminating Mounting evidence that eliminating exchange rate volatility by adopting a exchange rate volatility by adopting a common currency raises trade a lot:common currency raises trade a lot:

– estimates range from 50 per cent to 100 estimates range from 50 per cent to 100 per centper cent

– the the ‘border effect’‘border effect’ provides similar provides similar estimates.estimates.

Will Diversification Grow or Decline?Will Diversification Grow or Decline?

• Argument 1: intra-industry trade will Argument 1: intra-industry trade will grow.grow.

• Argument 2: specialisation will Argument 2: specialisation will increase.increase.

• No firm conclusion so far.No firm conclusion so far.

EMU and Labour MarketsEMU and Labour Markets

• Mobility may not change much, but wages could Mobility may not change much, but wages could become less sticky.become less sticky.

• Two views:Two views:– the virtuous circle: labour markets respond to the virtuous circle: labour markets respond to

enhanced competition by becoming more enhanced competition by becoming more flexibleflexible

– the hardening view: labour markets respond to the hardening view: labour markets respond to enhanced competition by increasing protective enhanced competition by increasing protective measures that raise stickiness.measures that raise stickiness.

• The jury is still out.The jury is still out.

Are the Other Criteria Endogenous?Are the Other Criteria Endogenous?

• Transfers:Transfers:

– currently no support for more taxes of currently no support for more taxes of finance transfers.finance transfers.

• Homogeneity of preferences:Homogeneity of preferences:

– no presumption that it will change soon.no presumption that it will change soon.

• Commonality of destiny:Commonality of destiny:

– no presumption that it will change soon.no presumption that it will change soon.

In the EndIn the End

• Monetary union is not only about economics.Monetary union is not only about economics.• The OCA criteria do not send a clear signal:The OCA criteria do not send a clear signal:

– the EU is not a perfect OCAthe EU is not a perfect OCA– a monetary union may function, at cost.a monetary union may function, at cost.

• The OCA criteria tell us where the costs will The OCA criteria tell us where the costs will arise:arise:– labour markets and unemploymentlabour markets and unemployment– political tensions in presence of deep political tensions in presence of deep

asymmetric shocksasymmetric shocks..