Lecture Presentation part 2 Why MU

Why Monetary Integration? Prof P. Nicolaides

The course road map

Evolution of EMU & rationale

Recent case law

Treaty provisions on EMU & capital

Banking Union: SSM & SRM

Crisis: State aid

Crisis: New rules & institutions

EMU - definition  Free trade of goods and services  Free movement of labour and capital  Single currency (or irrevocably fixed exchange rates and total convertibility)  Common monetary policy (interest rates)  (some) coordination of other policies • but, how much coordination of fiscal policy [public spending or taxation]?

But first, what is the role of exchange rates?  Exchange rate is instrument of economic adjustment  Example: Let $1 = €1  US firm invents new product everybody wants. It costs $4 = €4  European consumers buy it & competing European products lose market share  Demand for US $ increases => exchange rate becomes $1 = €1.5 [i.e. euro depreciates]  Price of US product in euros becomes €6 [= 4x1.5] => competing European products regain market share & competitiveness [cheaper both at home and in the US]

And, the risk from exchange rates  Problem: Fluctuations in exchange rates can be unpredictable => they increase risk & costs of trade and investment abroad     

Example: Let $1 = €1 US firm invests $100 mn in Europe = €100 mn And makes profit of 20% => its investment grows to €120 mn In the meantime exchange rate changes to $1 = €1.5 In dollars, profit of 20% turns to loss of 20% [120/1.5 = 80] Fluctuating currencies facilitate economic adjustment but make cross-border trade & investment risky

Why, then, single currency? Because there are benefits [decreasing at decreasing rate]; e.g. no transaction costs But also costs [increasing at decreasing rate]; e.g. sharing single monetary policy => There is no fixed answer – it depends on several factors [see next slides] Marginal Benefits

Makes sense to share same currency with country which is similar to yours and trades extensively with you MC

Marginal Costs

MB

N*

Number of countries sharing common currency

Benefits from MU  Microeconomic benefits • No transaction costs in foreign exchange • Elimination of exchange rate uncertainty – uncertainty discourages trade [estimated that euro increased trade by 5%]  Macroeconomic benefits • More credible monetary policy & lower inflation • ECB larger than any NCB [as provider of liquidity] • Improved international standing (€ as reserve currency)  Political benefits • Ability to influence monetary policy of “anchor” country

Costs from MU  One-size-fits-all monetary policy  Loss of exchange rate as instrument of adjustment => it means fiscal policy carries all burden of adjustment in case of uncorrelated shocks => need for adjustment via labour mobility, wages or productivity • Optimum currency area: defined as area with high factor mobility & correlated shocks  Conversion costs

What happens when regions within a country suffer shock?  Market mechanisms: • Adjustment through mobility: • Workers move from one region to another [if there is no mobility & wages do not adjust => unemployment] • Adjustment through risk sharing: • Cross ownership of assets • Integrated banking for lending and borrowing

Cont.  Policy mechanisms [solidarity]: • Fiscal adjustment: Expenditure & transfers [direct and indirect]: • Central govt increases spending in affected region • Affected region pays less taxes • Unemployed workers receive unemployment benefit from central govt • Unemployed workers get retrained; training may be funded by central govt

Cont.  In EU: • Limited labour mobility (only 3% of labour in another EU MS) • Banking & capital markets not fully integrated  In EU: No automatic transfers [which act as stabilisers] • US regions benefit from fiscal transfers: $1 nominal reduction of income = actual reduction of 60 cents (34% reduction in federal taxes + 6% federal transfers)  IMF (2013), Euro Area in Crisis: • % of asymmetric shocks felt by regions • Within US: 25% • Within DE: 20% • Within eurozone: 70%

Comparing currency unions

[K. O’Rourke & A. Taylor, Cross of Euros, Journal of Economic Perspectives, 2013]

The OCA logic: Max benefits, min costs The benefits: Are there large trade & investment flows between partner countries? Yes The costs: Are partner countries similar? [i.e. low likelihood of asymmetric shocks] Yes => OCA

No => needs economic adjustment mechanism

Are wages flexible or is labour mobility high? Yes => OCA

No => needs political adjustment mechanism Solidarity & transfers

The importance of risk sharing through capital markets

Conclusions  Theory of OCA suggests that case for MU is not absolute; it depends on the economies of partner countries  The EU is not an OCA  Most countries are not OCA; but they have risk-sharing & solidarity mechanisms that facilitate adjustment