oca

Information about oca

Published on April 10, 2008

Author: FunnyGuy

Source: authorstream.com

Content

The Euro: Theoretical Background:  The Euro: Theoretical Background The EU (except for UK, Sweden & Denmark) has been a monetary union since 1 Jan. 1999 The EU-12 have replaced their national currencies with a common currency the € Each has sacrificed policy independence to a unified central bank – the ECB The Euro: Theoretical Background:  The Euro: Theoretical Background Each country in the € must accept ECB decisions on interest rates and the external value of the currency against the $ The “one-size-fits-all” monetary policy Is there an economic justification for abandoning policy independence? The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) The OCA approach is a cost-benefit approach to monetary union. What are the costs & benefits? If the benefits are greater than the costs countries are suited to monetary union The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) The OCA approach: Under what conditions will the costs be low enough so as not to outweigh the benefits? OR: What characteristics must economies have to benefit from monetary union? The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) Benefits include: Eliminating exchange rate volatility Eliminating currency conversion costs Reducing trade costs Principal cost is the sacrifice of monetary independence and the exchange rate as a policy option. The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) Consider the U.K. If the U.K. were to join the euro what are the economic costs to the U.K? U.K. could not use monetary & exchange rate policy to stabilise its economy What do we mean by stabilisation policy? Dampen cyclical fluctuations in economic activity Slide7:  Growth Rate Time Y* Business Cycle Y* = Equilibrium Growth Rate High Growth Expansion Low Growth Recession The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) Stabilisation Policy Expansions: Moderate inflationary pressures by increasing interest rates & stronger currency Recessions: Moderate unemployment by reducing interest rates & weaker currency Note: Flexible exchange rates reinforce the effectiveness of monetary policy The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) Stabilisation Policy A fall in U.K. interest rates stimulates aggregate demand by: Reducing the cost of borrowing It also makes U.K. assets less attractive  capital outflow  sterling depreciation  increase in competitiveness  rise in net exports The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) Stabilisation Policy A rise in U.K. interest rates reduces aggregate demand by: Increasing the cost of borrowing It also makes U.K. assets more attractive  capital inflow  sterling appreciation  fall in competitiveness  fall in net exports The Optimum Currency Area (OCA):  The Optimum Currency Area (OCA) Cost of sacrificing policy independence are likely to be low when Labour markets are flexible (Robert Mundell Model Am. Econ. Review 1961) Shocks are symmetric & business cycles synchronised Flexible Labour Markets:  Flexible Labour Markets Wages adjust to unemployment and/or labour is mobile Treat relative wages as a measure of competitiveness and Distinguish between nominal and real exchange rates: UK & Eurosystem Flexible Labour Markets:  Flexible Labour Markets Nominal: s = amount of € per unit of the U.K.’s currency (£) Let w£ = measure of production costs in U.K. in £ Let w€ = measure of production costs in the Eurosystem in € Hence sw£ measures w£ in € Real: q = (sw£/w€) Flexible Labour Markets:  Flexible Labour Markets Example: Let s = 2 or £1 = €2 wA = £75 wB = €200 sW€ = £150 Hence: q = 150/200 = 0.75 Measures UK’s relative competitiveness Fall in q (real depreciation) competitive gain Rise in q (real appreciation) competitive loss Flexible Labour Markets:  Flexible Labour Markets Consider a shock which leads to higher unemployment in the U.K. only (asymmetric) How does the U.K. adjust? Two scenarios: U.K. has policy independence U.K. is a member of the euro Flexible Labour Markets:  Flexible Labour Markets Policy Independence: q =(sw£/w€) U.K. cuts interest rates: Stimulates consumption & investment Capital outflow  £ depreciation (s falls)  q falls  real depreciation  competitive gain  increase in net exports Flexible Labour Markets:  Flexible Labour Markets Monetary Union: q =(sw£/w€) U.K. cannot cut interest rates & £ cannot depreciate What if higher unemployment forces a fall in w£? More realistically the rate of change in w£ falls below the % change in w€ q falls  real depreciation  competitive gain  increase in net exports Hence flexible labour markets can compensate for the loss of policy independence Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Shock: Fall in demand/consumer confidence: rise in oil prices etc. Symmetric: Affects different countries in the same way Asymmetric: Affects different countries in the different ways Countries which experience symmetric shocks are best suited to monetary union Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Symmetric: Suppose U.K. & France experience recession at the same time Appropriate policy response will be the same in each country Both U.K & France will want to lower interest rates & depreciate their currencies Having national currencies & policy independence may be of little advantage Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Symmetric: Suppose U.K. & France experience inflation at the same time Appropriate policy response will be the same in each country Both U.K & France will want to raise interest rates & appreciate their currencies Having national currencies & policy independence may be of little advantage Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Asymmetric: Suppose U.K. experiences recession & France experience inflation Appropriate policy responses will differ U.K: Lower interest rates & weaker currency France: Higher interest rates & stronger currency Cost of sacrificing policy independence may be high Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Put another way: Symmetric shocks: one-size or single monetary policy fits both Asymmetric shocks: one-size or single monetary policy may fit neither Countries are best suited to monetary union when shocks are symmetric Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Consider a shock such as a rise in world oil prices. France and Germany are equally dependent on imported oil - the shock affects them in similar ways (symmetric) If their preferred policy responses are the same then it may be more efficient to have a common or unified response rather than similar or duplicated national responses. Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Hence, being in a monetary union may be of benefit and the loss of policy independence impose a small cost. EG: Both may wish to raise interest rates A common policy may be at least as efficient as independent but similar policies Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks However consider the UK with oil production. The shock has different implications for the UK (asymmetric) and the preferred policy options may differ from those of France & Germany. Hence, the UK might find it costly to be in a monetary union with France & Germany. Example: Euro Depreciation::  Example: Euro Depreciation: BOE simulation: Euro depreciates 10% against $. Effect on Inflation over two years: France: Year 1: 0.6 Year 2: 1.6 Germany: Year 1: 0.4 Year 2: 1.1 Ireland: Year 1: 1.8 Year 2: 4.5 Depreciation of the euro is symmetric for France & Germany but asymmetric for Ireland. Ireland’s “optimal” policy response (higher interest rates, stronger currency) will differ from France & Germany. Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Ireland 1999-2000: Inflation 7% euro average 2% Ireland required a stronger currency & higher interest rates But depreciating euro & ECB policy delivered a weak currency & low interest rates The “one-size” policy did not fit Ireland Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks More generally, economies are best suited to monetary union (form an OCA) if their business cycles are synchronised Experience periods of recession and growth at the same time. When business cycles are synchronised shocks are more likely to be symmetric & countries will require similar policies at the same time Symmetric & Asymmetric Shocks:  Symmetric & Asymmetric Shocks Low interest rates in recession, higher interest rates in inflationary booms. However, if business cycles are not synchronised then The one-size policy may be inappropriate – U.K. needs low interest rates, France needs high interest rates etc. Slide31:  Correlation With GER Correlation with USA Industrial Structures & Trade:  Industrial Structures & Trade The cost of sacrificing policy independence is likely to be relatively low if business cycles are synchronised with that of the euro area Under what conditions are business cycles likely to be synchronised? When countries produce & trade similar products Industrial Structures & Trade:  Industrial Structures & Trade Suppose the U.K. and France both produce two goods: Financial Services (FS) & Manufactures (MANU) A shock to either sector is symmetric Slow down in world demand for FS will affect both They will face similar problems & require similar policies Industrial Structures & Trade:  Industrial Structures & Trade Suppose the U.K. is heavily specialised in FS & France in MANU A shock to either sector is asymmetric Slow down in world demand for FS will affect the U.K. more than France They will face different problems & require different policies Industrial Structures & Trade:  Industrial Structures & Trade However suppose the U.K. is a major importer of French MANU & France is a major importer of British FS Fall in demand for FS leads to a downturn in U.K. As U.K. grows slows French exports of MANU will decline & France will also experience a downturn Industrial Structures & Trade:  Industrial Structures & Trade Likewise, a fall in demand for MANU leads to a downturn in France As French growth slows U.K. exports of FS will decline & the U.K. will also experience a downturn Trade implies interdependency and linkages between economies. Industrial Structures & Trade:  Industrial Structures & Trade Hence economies are more likely to be synchronised if they produce similar goods and/or trade extensively with each other Similar industrial structures and trade imply that economies are highly integrated and more likely to have synchronised business cycles Hence for an economy such as the U.K. the cost of sacrificing policy independence will decline with the degree of integration with the euro area. Benefits:  Benefits Benefits include: Eliminating exchange rate volatility Eliminating currency conversion costs Reducing trade costs Other things equal the benefits are likely to increase with trade & integration. Costs & Benefits:  Costs & Benefits Other things equal the costs are likely to decrease with trade & integration Other things equal the benefits are likely to increase with trade & integration. Two curves BB: relates benefits to integration (positive) CC: relates costs to integration (negative) Slide40:  Costs Benefits Integration CC BB Net Loss Net Gain I* I* is the break-even level of integration Mr. Brown’s Five Economic Tests:  Mr. Brown’s Five Economic Tests The Convergence Test: Are business cycles and economic structures compatible so that the U.K. could live with euro interest rates? The Flexibility Test: If problems emerge is there sufficient flexibility to deal with them? The Investment Test: Would joining the euro create better conditions for firms making long-term decisions to invest in the U.K.? The Financial Services Test: What impact would joining the euro have on the financial services industry? The Growth and Employment Test: Will the euro promote higher economic growth and a permanent increase in employment? Mr. Brown’s Five Economic Tests:  Mr. Brown’s Five Economic Tests Tests announced in Oct. 1997, first assessment May 2003: U.K. passed the investment and financial services tests Convergence and flexibility were not satisfied. First two tests were also deemed to be preconditions for meeting the growth and employment test Britain not ready for the euro Mr. Brown’s Five Economic Tests:  Mr. Brown’s Five Economic Tests It appears that the U.K. fails 2 key OCA criterion: Flexibility & Convergence Should the U.K. wait for greater convergence with the euro area? Perhaps not: Slide44:  Costs Benefits Integration CC BB Net Loss I* I' U.K. at I' < I* net loss = AB A B Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence Hypothesis: Using a common currency promotes trade among partner countries Berkeley Economist Andrew Rose: Data set for approx. 200 countries Principal finding: Trade between countries using the same currency can be up to three times greater than between countries using different currencies Common Currencies & Trade.:  Common Currencies & Trade. Barriers to trade take many forms – tariffs, quotas, non-tariff barriers, distance etc. Is the use of national currencies a barrier to trade? National currencies imply transactions costs and exchange rate uncertainty/risk. If these limit trade then their removal by a common currency may promote trade. Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence As trade promotes closer interdependency it leads to faster integration & convergence. Common currency  Trade  Convergence If Rose is correct then the U.K. can most easily meet the convergence test by joining now! Using the euro moves the U.K. closer to the break-even level of integration I* Slide48:  Costs Benefits Integration CC BB Net Loss I* I' Common currency  Trade  Convergence I  I* Net Loss Net Loss Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence Is Rose correct? Data set includes monetary unions between small countries with little in common with Europe Few examples of forming monetary unions More of dissolving monetary unions Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence Is the effect symmetric? If forming a union promotes trade does dissolving a union reduce trade? Most unions end because of war, sanctions etc. Trade would have collapsed irrespective of the currency used One exception: Ireland & the U.K. – monetary union ended when U.K. opted out of the ERM. Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence Thom & Walsh (European Economic Review June 2002) Ending the sterling-link had no effect on Anglo-Irish trade Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence Does the type of trade matter? Two types: Inter-Industry Trade Different Products Intra-Industry Trade Similar Products Common Currencies, Trade & Convergence :  Common Currencies, Trade & Convergence Intra-Industry Trade Countries produce & trade a similar range of products Shocks are more likely to be symmetric Inter-Industry Trade Countries are specialised Shocks are more likely to be asymmetric Common Currencies & Trade.:  Common Currencies & Trade. Alternative view, Paul Krugman: Integration (SM, euro etc) promotes greater specialisation & inter-industry trade leading to divergence and lower correlation. Free trade  national/regional specialisation in a narrower range of products  greater incidence of asymmetric shocks  lower correlation. Common Currencies & Trade.:  Common Currencies & Trade. Krugman: The EU will become “more like America” Single Market Common Currency etc. US “regions” are more specialised than EU countries. Common Currencies & Trade.:  Common Currencies & Trade. Regional concentration is typical of many U.S. industries - aircraft production on West coast (Seattle) As U.S. is a large integrated market with a common currency then economic integration in Europe may lead to a similar type of distribution. Common Currencies & Trade.:  Common Currencies & Trade. Example: Distribution of Car Production: EU: Germany 38.5% France 31.1 Italy 17.6 UK 12.9 Common Currencies & Trade.:  Common Currencies & Trade. Example: Distribution of Car Production: US: Midwest 66.3 South 25.4 West 5.1 North-East 3.3

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