Chapter 4: Costs and Benefits Compared

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Chapter 4Costs and Benefits Compared

• De Grauwe
• Economics of Monetary Union

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Costs and benefits of a monetary union
Benefits
Costs and Benefits ( GDP)
Costs
Trade ( GDP)
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Two views about costs and benefits of MU
(a) The monetarist view
(b) The Keynesian view
Benefits
Benefits
Costs and benefits
Costs and benefits
Costs
Costs
T
T
Trade ( GDP)
Trade (GDP)
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Two views about costs of MU

• The 'monetarist view
• Monetary policies are ineffective as instruments
  to correct for different developments between
  countries
• The cost curve is close to the origin
• Thus, many countries in the world would gain by
  relinquishing their national currencies, and by
  joining a monetary union

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• The 'Keynesian' view
• The world is full of rigidities
• Monetary policy (including exchange rate policy)
  is a powerful instrument in eliminating
  disequilibria
• The cost curve is far away from the origin
• Relatively few countries should find it in their
  interest to join a monetary union

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• Since the early 1980s the 'monetarist' view has
  gained adherents, and has changed the view many
  economists have about the desirability of a
  monetary union
• The popularity of monetarism helps to explain why
  EMU became a reality in the 1990s

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Costs and benefits with decreasing rigidities

• With decline in wage and price rigidities and an
  increase in labour mobility
• Cost curve shifts downwards
• Monetary union becomes more attractive

Benefits
Costs and benefits
Costs
T
T
Trade ( GDP)
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Is EMU an optimal currency area?

• In order to answer to this question there are
  different parameters to evaluate
• Intra-EU trade
• Degree of rigidities
• Degree of asymmetry of shocks

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Table 4.1 Intra-union exports of EU countries (
of GDP) in 2005

• Large differences in openness of EU countries
  with the rest of the Union
• For countries with a small degree of openness (UK
  and Greece), it is less clear that they belong to
  an optimal currency area with the rest of the EU
• Cost-benefit analysis is likely to show net
  benefits of being in EMU for Benelux, and small
  central European countries

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Asymmetric shocks and labour market flexibility

• Not only the degree of labour market flexibility
  which matters for determining whether a monetary
  union will be attractive to countries
• Also asymmetry in demand and supply shocks
  matters
• There is a link between labour market flexibility
  and asymmetric shocks in a monetary union

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Asymmetric shocks and labour market flexibility
in monetary unions

• Downward sloping OCA-line shows minimum
  combinations of symmetry and flexibility that
  countries must have in order for a monetary union
  to provide more benefits than costs
• Countries or regions located below the OCA line
  do not have enough flexibility given the level of
  symmetry they face
• Countries to the right of the OCA line have a lot
  of flexibility given the level of symmetry they
  face
• Evidence about how many countries in EU form OCA
  is not clear-cut

• Eurozone

Symmetry

• USA

• EU-25

OCA
Flexibility
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• The challenging task for the EU-25 is to move to
  the other side of the OCA-line, i.e. to make a
  monetary union less costly
• How can this be achieved? There are essentially
  two strategies
• Reduce the degree of real divergence (political
  union)
• Increase the degree of flexibility of labour
  markets

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Case-study

• During the early 1980s the industrial world was
  hit by a severe recession
• Two examples
• Michigan in the USA
• Belgium in Europe
• Both regions are of a comparable size
• Unemployment increased significantly more in
  Michigan and Belgium than in the USA and in
  Europe, respectively.

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• How did these two regions adjust?
• In Michigan mainly outward migration
• In Belgium mainly real depreciation
• This helped to restore competitiveness, and
  started a process of gradual recovery leading to
  a significant narrowing of the unemployment
  differential between Belgium and the EC

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• Case-study suggests that even small countries
  like Belgium, for which the benefits of being in
  EMU probably outweigh the costs, have taken some
  risk
• When in the future they will be subject to large
  shocks they will not have a national monetary and
  exchange rate instrument to soften the blow
• As a result, given the rigidity of their labour
  markets, the adjustment to such large
  disturbances is likely to be painful

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Costs and benefits in the long run
The European Commission view of monetary
integration

• Upward sloping line (TT) because as trade
  integration increases the degree of symmetry
  between the countries involved declines
• Downward sloping line (OCA)
• Less symmetry makes a monetary union more costly.
  More integration reduces the costs of a monetary
  union. Thus a reduction in symmetry must be
  compensated by more integration to make a
  monetary union worthwhile (in terms of costs and
  benefits)
• Points on OCA line are minimal combinations of
  symmetry and integration for which monetary union
  has zero net gain

T
Symmetry
EU-25
OCA
T
Trade integration
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Costs and benefits in the long run
The pessimistic view of monetary integration
T
T
EU-25
Symmetry
T
OCA
T
Trade integration
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• Two possibilities for the long-term prospects of
  monetary union
• One is represented by the TT line. In this case,
  although today the EU-25 may not be an optimum
  currency area, it will move into the OCA zone
  over time (right side of OCA)
• The second case is represented by the steep TT
  line. Integration brings us increasingly farther
  away from the OCA zone. The net gains of a
  monetary union do not increase fast enough with
  the degree of integration. Thus, the costs of
  asymmetry overwhelm all the other benefits a
  monetary union may have
• Second case is implausible

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Endogeniety of monetary union

• A decision by an individual country to join EMU,
  even if it does not satisfy the OCA criteria, can
  have a self-fulfilling character
• In this case the process of integration is sped
  up by the very decision to join the monetary
  union, so that this new country grouping moves
  faster into the OCA zone
• OCA becomes endogenous

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The challenge of enlargement of EMU

• Two challenges
• Enlargement poses problems for the 12 present
  members
• Enlargement poses problems for the newcomers

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Is Euro-25 OCA? Openness as a criterion
Figure 4.11 Exports of goods and services
towards EU-25 as percentage of GDP (2005)
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• The central European countries are as open
  towards the EU as the EU-countries themselves
• The central European countries appear to be more
  integrated with the EU than Denmark, Sweden and
  the UK

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Is Euro-25 OCA? Asymmetry of shocks

• Each point represents correlation between demand
  and supply shocks of particular country with
  EU-average
• Many CE-countries demand shocks negatively
  correlated with EU demand shocks
• Low correlation of supply shocks between
  CE-countries and EU
• Asymmetries in demand shocks may disappear partly
  in MU, asymmetries in supply shocks more likely
  to stay

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• Thus, not all CE-countries may be part of an
  optimal currency area with the rest of the
  European Union
• Despite relatively large openness of the
  CE-countries vis a vis the EU, many are subjected
  to relatively large asymmetric shocks, so that it
  is not obvious that they would gain from entering
  EMU
• However, for some of these countries entering EMU
  might be the best possible way to import monetary
  and price stability

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How will present members be affected by
enlargement to Euro-25?
symmetry

• Euro-25 more subject to asymmetric shocks than
  Eurozone
• Original members of Eurozone (who are also part
  of Euro-25) are thrown out of OCA-zone
• Some original members will perceive policies of
  the ECB to be less receptive to their domestic
  shocks than prior to enlargement

Eurozone
OCA
EU-25
Economic integration
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Should the UK join EMU?

• Costs of a monetary union
• Openness the UK has the lowest degree of
  openness towards the rest of the EU
• Asymmetry of shocks demand shocks in the UK are
  negatively correlated with the demand shocks in
  Euroland
• Flexibility there is greater flexibility in the
  UK labour markets than in the Eurozone (see the
  inflation-unemployment of the UK, France and
  Germany). Thus easier adjustment in UK than in
  Eurozone
• It is unclear whether costs of monetary union are
  larger in UK than in Eurozone

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Is Latin America an optimal currency area?

• Monetary instability has made the idea of forming
  a monetary union in Latin America popular
• Costs of monetary union in Latin America
• Latin American countries have very low levels of
  trade with the rest of Latin America

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Figure 4.16 Intraregional exports of goods and
services, EU and Latin America as a percentage of
GDP (2005)
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• Degree of synchronization of output movements is
  low in Latin America, and asymmetric shocks are
  relatively large
• Very little empirical evidence has been
  undertaken to measure the degree of flexibility
  of labour markets
• Main driving force for popularity of MU is the
  hope to import price stability
• If monetary union comes about it will have to
  provide the right institutions guaranteeing price
  stability

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Is East-Asia an optimal currency area?
Source IMF, IFS and Xu Ning(2004) Note the
exports of the East-Asian countries is to ASEAN
plus China, Korea and Japan. The data for China
relate to 2001.
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Shocks are not more asymmetric in Asia than in
Eurozone
Eurozone
Asia
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• Economic conditions for monetary union in East
  Asia seem to be satisfied
• Main stumbling block is political
• Desire for political unification is weak
• Contrast with Europe is great process of
  political unification in Europe has been going on
  since 1960

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Monetary Unions in Africa

• There is a history of monetary union in West- and
  Central Africa
• Legacy of colonization CFA-zone
• New initiative to extend existing monetary
  unions The Economic Community of West-African
  States (ECOWAS)
• This is a grouping of 15 states
• Do these form an OCA?

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Figure 4.20 Intraregional exports of goods and
services in West-Africa (2003) and the Eurozone
(2005)
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• When using the Eurozone as a benchmark, the
  evidence on whether West Africa forms an optimal
  currency area is mixed
• The degree of integration among West African
  countries is low, yielding relatively few
  benefits of a monetary union
• Labour mobility is substantially stronger
• The degree of asymmetry does not seem to be
  larger in West Africa than it is in the Eurozone
• West African countries (the members of WAEMU)
  have already set into place a series of
  institutions, such as a common central bank
  facilitating further steps towards a monetary
  union

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Conclusion

• It is unlikely that the EU as a whole constitutes
  an optimal monetary union
• As integration moves on, the number of countries
  that are likely to benefit from monetary union
  will increase
• Enlargement of the Eurozone to 25 countries
  creates serious challenges
• Euro-25 is probably not an OCA, but may become
  one
• Enlargement will change the cost benefit calculus
  of existing members of the Eurozone. Some of
  these member countries may find out that the
  enlargement makes the monetary union less
  attractive

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• It is unlikely that Latin America and East Asia
  will come to monetary union soon, although
  reasons are different
• Evidence about West-Africa as an OCA is mixed
• Our analysis has been based on an economic
  cost-benefit analysis. Countries may also decide
  to adopt a common currency for political reasons
• The economic cost-benefit analysis remains
  useful, because it gives an idea of the price
  some countries will have to pay to achieve these
  political objectives