Economics of Monetary Union
Chapter 1: The Costs of a Common Currency
Introduction
What a country loses when it enters a Monetary Union
- It loses the ability to conduct a national monetary policy (to deal with asymmetric shocks)
- Inability to stabilize national output in a Monetary Union
- Inability to control national interest rate (+ Level of investment)
- Loss of control leads to vulnerability of national governments to liquidity crises
- Differences in labor market institutions between member states leads to inequality
- Differences in legal systems between member states also leads to inequality (+ Costs)
Monetary Union (MU)
= Set of countries that have abandoned their national currencies to use a common currency,
controlled by one, common Central Bank
1.1 Shifts in Demand
Based on Mundell-Fleming Model
- Robert Mundell (1961): Theory of Optimum Currency Areas
- Assume two countries: France + Germany
- Symmetric shock = Affects all regions/countries in the same manner
- Asymmetric shock = Change in economic conditions that affects different countries in a
different way
In case of a symmetric shock
- Common central bank in MU can deal with these kind of shocks
- Common policy stabilizes both German + French economy
- MU (+ common policy) is now more attractive than different monetary policy
- Better to coordinate policies in case of a symmetric shock
In case of an asymmetric shock
- Permanent shock ( Due to changes in consumer preferences)
- Increase in aggregate demand in Germany
- Decrease in aggregate demand in France
- Common CB of MU can’t deal with this issue ( Conflicting desires of member states)
- Monetary independency is now more attractive compared to MU
- Example: Reunification of East and West Germany in 1989 ( Restrictive monetary policy)
Symmetric shock Asymmetric shock
, MU can be costly, unless there is
1. Wage flexibility
- Unemployment rises in France and decreases nominal wages ( Recession in France)
- Aggregate supply in France shifts downwards ( Labor demand > Labor supply)
- Excess demand for labor in Germany pushes up the nominal wages
- In France, price of output declines and makes products more competitive
- The opposite happens in Germany and makes products less competitive ( More costly)
- This shift in demand is called the automatic adjustment process
2. Labor mobility
- French unemployed move to Germany
- Solves unemployment problems in France and excess demand for labor in Germany
- Very limited in Europe ( Wages are still very rigid)
- Primarily on the level of high skilled worked
When not in a MU
- France applies expansionary monetary policy and reduces interest rate
- This stimulates private investment and net export ( Aggregate demand shifts to the right)
- Germany adopts a restrictive monetary policy and raises interest rate
- This decreases private investment and lowers competitivity of Germany
,1.2 Monetary independence and government budgets
When countries join a MU, it reduces the capacity to finance budget deficits
- Countries have no control over monetary policy ( Controlled by CB)
- National governments can no more guarantee 100% payback of all debts
- Countries become more vulnerable to distrust of investors
UK scenario
- Suppose investors fear default of UK government ( UK government bonds are being sold)
- Supply of bonds increases Price decreases and interest rate increases
- Proceeds of sales are being traded in the forex market Pound depreciates
- UK money stock remains on the same level ( Only price of the currency changes)
- This will not lead to any liquidity problems in the UK
Spanish scenario
- Investors fear default of Spanish government ( Spanish government bonds are sold)
- Interest rate increases (due to larger supply of bonds)
- Proceeds of these sales are reinvested in other Eurozone assets
- Spanish money stock declines + lower liquidity in Spain
- No floating exchange rate to counter this issue ( Value of Euro is fixed for all members)
- Leads to liquidity crisis Spanish government can’t guarantee 100% payback of bonds
- Liquidity crisis can turn into a solvency crisis
1.3 Asymmetric shocks and debt dynamics
- Negative shock in France increases budget deficit in France
- Positive shock in Germany increases budget surplus in Germany
- If markets lose trust in solvency of French government Asymmetric shock is amplified
Investors sell French government bonds
- Causes increase in the interest rate
- Causes liquidity crisis in France
- Lower C + I in France AD moves left
Investors buy German government bonds
- Interest rate declines in Germany
- More C + I in Germany AD moves right
Asymmetric shock is amplified
Shouldn’t interest rates be the same in a MU?
- Yes, for short-term interest rate set by ECB
- Not for interest rates on long-term government bonds
- Long-term government bonds contain a risk premium ( Based on risk of default)
Covid-19 Pandemic also caused an asymmetric shock
, 1.4 Booms and busts in a MU ( Temporary asymmetric shocks)
2 possible scenarios in a MU:
1) Investors remain trust in French government
- Investors are willing to buy extra French bonds
- Interest rate remains unchanged
- Investors buy less German government bonds
- Capital market Stabilizing role
2) Investors lose trust in French government
- Investors sell French government bonds
- Investors buy German government bonds
- Interest rate increases in France and decreases in Germany
- Capital market Destabilizing role
1.5 Monetary and budgetary union
MU’s can be fragile
- Asymmetric shocks Adjustment problems, unless there is wage flexibility/labor mobility
- Adjustment problems are even worse if MU-members have low liquidity/solvency
Costs of a MU can be reduced by
- Unlimited liquidity support for bondholders by the CB ( This is not attainable in practice)
- A budgetary union ( Further financial integration/participation between member states)
Budgetary union
1) Insurance mechanism with ex-post transfers
- Automatic stabilization without a deficit in France or surplus in Germany
- Redistribution of tax revenues on European level “Consumption smoothing”
- Extra tax revenues in Germany are used to finance unemployment expenditures in France
- Moral hazard These transfers reduce competitiveness and create political resistance
- Permanent labor market differences between countries are the result of different labor
market policies and institutions ( Related to design of the labor market)
2) Provides protection against a liquidity crisis
- European centralized government that issues European bonds ( In a budgetary union)
- This eliminates capital movement from one bond market to another
- Eliminates all possible future liquidity crises of member states
- Requires political unification and transfer of power/sovereignty to European level
- Very hard to achieve in practice ( No real political willingness from member states)
MU without a budgetary union is an incomplete MU
- Monetary union + budgetary union Full MU
- USA is a better example of a full MU
1.6 Private insurance systems
- Budgetary union Public insurance scheme (against liquidity crises)
- Capital market union Private insurance scheme (against liquidity crises)
Chapter 1: The Costs of a Common Currency
Introduction
What a country loses when it enters a Monetary Union
- It loses the ability to conduct a national monetary policy (to deal with asymmetric shocks)
- Inability to stabilize national output in a Monetary Union
- Inability to control national interest rate (+ Level of investment)
- Loss of control leads to vulnerability of national governments to liquidity crises
- Differences in labor market institutions between member states leads to inequality
- Differences in legal systems between member states also leads to inequality (+ Costs)
Monetary Union (MU)
= Set of countries that have abandoned their national currencies to use a common currency,
controlled by one, common Central Bank
1.1 Shifts in Demand
Based on Mundell-Fleming Model
- Robert Mundell (1961): Theory of Optimum Currency Areas
- Assume two countries: France + Germany
- Symmetric shock = Affects all regions/countries in the same manner
- Asymmetric shock = Change in economic conditions that affects different countries in a
different way
In case of a symmetric shock
- Common central bank in MU can deal with these kind of shocks
- Common policy stabilizes both German + French economy
- MU (+ common policy) is now more attractive than different monetary policy
- Better to coordinate policies in case of a symmetric shock
In case of an asymmetric shock
- Permanent shock ( Due to changes in consumer preferences)
- Increase in aggregate demand in Germany
- Decrease in aggregate demand in France
- Common CB of MU can’t deal with this issue ( Conflicting desires of member states)
- Monetary independency is now more attractive compared to MU
- Example: Reunification of East and West Germany in 1989 ( Restrictive monetary policy)
Symmetric shock Asymmetric shock
, MU can be costly, unless there is
1. Wage flexibility
- Unemployment rises in France and decreases nominal wages ( Recession in France)
- Aggregate supply in France shifts downwards ( Labor demand > Labor supply)
- Excess demand for labor in Germany pushes up the nominal wages
- In France, price of output declines and makes products more competitive
- The opposite happens in Germany and makes products less competitive ( More costly)
- This shift in demand is called the automatic adjustment process
2. Labor mobility
- French unemployed move to Germany
- Solves unemployment problems in France and excess demand for labor in Germany
- Very limited in Europe ( Wages are still very rigid)
- Primarily on the level of high skilled worked
When not in a MU
- France applies expansionary monetary policy and reduces interest rate
- This stimulates private investment and net export ( Aggregate demand shifts to the right)
- Germany adopts a restrictive monetary policy and raises interest rate
- This decreases private investment and lowers competitivity of Germany
,1.2 Monetary independence and government budgets
When countries join a MU, it reduces the capacity to finance budget deficits
- Countries have no control over monetary policy ( Controlled by CB)
- National governments can no more guarantee 100% payback of all debts
- Countries become more vulnerable to distrust of investors
UK scenario
- Suppose investors fear default of UK government ( UK government bonds are being sold)
- Supply of bonds increases Price decreases and interest rate increases
- Proceeds of sales are being traded in the forex market Pound depreciates
- UK money stock remains on the same level ( Only price of the currency changes)
- This will not lead to any liquidity problems in the UK
Spanish scenario
- Investors fear default of Spanish government ( Spanish government bonds are sold)
- Interest rate increases (due to larger supply of bonds)
- Proceeds of these sales are reinvested in other Eurozone assets
- Spanish money stock declines + lower liquidity in Spain
- No floating exchange rate to counter this issue ( Value of Euro is fixed for all members)
- Leads to liquidity crisis Spanish government can’t guarantee 100% payback of bonds
- Liquidity crisis can turn into a solvency crisis
1.3 Asymmetric shocks and debt dynamics
- Negative shock in France increases budget deficit in France
- Positive shock in Germany increases budget surplus in Germany
- If markets lose trust in solvency of French government Asymmetric shock is amplified
Investors sell French government bonds
- Causes increase in the interest rate
- Causes liquidity crisis in France
- Lower C + I in France AD moves left
Investors buy German government bonds
- Interest rate declines in Germany
- More C + I in Germany AD moves right
Asymmetric shock is amplified
Shouldn’t interest rates be the same in a MU?
- Yes, for short-term interest rate set by ECB
- Not for interest rates on long-term government bonds
- Long-term government bonds contain a risk premium ( Based on risk of default)
Covid-19 Pandemic also caused an asymmetric shock
, 1.4 Booms and busts in a MU ( Temporary asymmetric shocks)
2 possible scenarios in a MU:
1) Investors remain trust in French government
- Investors are willing to buy extra French bonds
- Interest rate remains unchanged
- Investors buy less German government bonds
- Capital market Stabilizing role
2) Investors lose trust in French government
- Investors sell French government bonds
- Investors buy German government bonds
- Interest rate increases in France and decreases in Germany
- Capital market Destabilizing role
1.5 Monetary and budgetary union
MU’s can be fragile
- Asymmetric shocks Adjustment problems, unless there is wage flexibility/labor mobility
- Adjustment problems are even worse if MU-members have low liquidity/solvency
Costs of a MU can be reduced by
- Unlimited liquidity support for bondholders by the CB ( This is not attainable in practice)
- A budgetary union ( Further financial integration/participation between member states)
Budgetary union
1) Insurance mechanism with ex-post transfers
- Automatic stabilization without a deficit in France or surplus in Germany
- Redistribution of tax revenues on European level “Consumption smoothing”
- Extra tax revenues in Germany are used to finance unemployment expenditures in France
- Moral hazard These transfers reduce competitiveness and create political resistance
- Permanent labor market differences between countries are the result of different labor
market policies and institutions ( Related to design of the labor market)
2) Provides protection against a liquidity crisis
- European centralized government that issues European bonds ( In a budgetary union)
- This eliminates capital movement from one bond market to another
- Eliminates all possible future liquidity crises of member states
- Requires political unification and transfer of power/sovereignty to European level
- Very hard to achieve in practice ( No real political willingness from member states)
MU without a budgetary union is an incomplete MU
- Monetary union + budgetary union Full MU
- USA is a better example of a full MU
1.6 Private insurance systems
- Budgetary union Public insurance scheme (against liquidity crises)
- Capital market union Private insurance scheme (against liquidity crises)
