Optimum Currency Area Theory

1. Optimum Currency Area Theory Grzegorz Tchorek Ph.D. Warsaw University

2. I have very king request…

3. The outline of our course • Evolution of the OCAtheory, which has a lot of weaknesses as an analytical framework, but is the only one relatively coherent economic approach to monetary integration. • Experiences of the euro area and causes of the crisis and we will try to juxtapose what we thought about the euro area functioning before the euro creation and before the crisis and what happened as a result of the crisis. • Reforms and prospects of the euro area and the UE

4. Is the euro area safer now ?

5. The euro zone: Is this really the end? EconomistNovember 26, 2011 THURSDAY, NOVEMBER 24, 2011 The euro zone: Is this really the end? EconomistNovember 26, 2011 „Super Mario” saved the euro ?

6. Theoretical aspects of monetary integration, - Evolution of the Optimum Currency Area (OCA)

7. Arguments in favour of the euro adoption • Direct effects • Elimination of the costs related to zloty/euro exchange rate transactions • Elimination of exchange rate risk • Decline in interest rates (mainly long term) • Long-term benefits • Investment growth (FDI) • Trade expansion • Decrease in the country’s macroeconomic risk • Financial markets integration ( home bias) • Increased competition • More stable environment

8. Costs and threats of the euro adoption - arguments for slow monetary integration • Monetary union membership involves major macroeconomic costs: • Giving up an independent interest rate policy and a floating exchange rate, • The risk of ECB monetary policy being inappropriate for the Polish economy • Potential short-term cost of meeting the inflation criterion • …and also changeover costs

9. In order to recognize benefits, costs, opportunities, threats and challenges on the road to euro area we will turn to the economic theory and empirical studies The basis is still OCA theory … in its old (real convergence) and new (nominal convergence) view

10. Two opposite views on the monetary integration • Nominalconvergence • Gives a lot of profits(elimination of exchange raterisk, morestable environment, more trade and investment), • The credibilityissueand the importance of a nominalanchor in monetaryunion, • Endogenouseffects • Real convergence • How to avoidasymmetricshocksafterabandoningmonetary policy ? • (susceptibilityto shocks) • How to cope with theseshocks ? • (economicflexibility)

11. Nominal convergence approach induces fast joining, • Real convergence approach indicates rather gradual integration,

12. The “Pioneering Phase” - from the early 1960s to the early 1970s • The OCA theory emerged from the debate on the merits of fixed versus flexible exchange rate regimes • The pioneering phase initiated a debate on the benefits and costs of adopting a single currency. • “Problem of inconclusiveness” - as OCA properties may point out different directions, • Several properties were difficult to measure accurately and evaluate

13. P - Price level, Q- Quantity of production, S – aggregate supply curve, D- aggregate demand curve

14. How can we restore balances in two countries?

15. The first option is Exchange rate policy • Germany can revalue its currency/ or if they have a floating exchange rate, it will probably appreciate automatically • Spain can devalue its currency/ or if they have a floating exchange rate, it will probably depreciate Spain currency • The second option is Monetary policy • Spain can decrease its interest rates in order to help firms and households • Germany can increase its interest rates in order to avoid excessive surplus and inflation • The third option is fiscal policy • Spain can decrease taxes • Greece can increase taxes • In a fiscal union transfer between countries can be used as a shock absorber • …The fourth option is structural policy– but in a long run..

16. Mundell and his successors stated that one country can give up its monetary and exchange rate policy when it fulfills some criteria which are called optimum currency area conditions. • They constitute a substitution mechanisms to the monetary policy

17. The main issues of the OCA are: • How to cope with these shocks ? (economic flexibility) • How to avoid asymmetric shocks ? (susceptibility to shocks)

18. Factors which help countries to cope with shocks • Production factors mobility (including labour) – (Mundell 1961, Corden 1972) • Price and wage flexibility (labour and product market flexibility) – (Friedman 1953, Mundell 1961) • Financial market integration (Ingram 1962) • Fiscal integration (Kenen 1969)

19. Production factors mobility, mainly labour mobility – unemployed Spaniards should go to work to Germany • But labour mobility is constrained by a lot of factors like cultural and language differences, the lack of a common social benefit system, etc. • Finally, Mundell diminished the importance of this criterion because people cannot move in reaction to every shock (particular shocks repeat with every economic cycle, it can have different consequences in the phase of crisis even if countries are highly synchronized during a boom ). • On the other hand, nowadays, justification for labour mobility is lower because factories follow labour (FDI)

20. Labour market integration • There are significant barriers in the housing markets across the EU. • A panel of experts set up by the EU attributes low labour mobility to a combination of institutional and administrative factors including: • limited cross border portability of social protection and supplementary pension rights; • administrative difficulties and the high costs of gaining legal resident status; • lack of comparability and reciprocal recognition of professionalqualifications; • and restrictions on public sector employment.

21. Wage and price flexibility • According to the theory, people in the country affected by a negative shock should be able to decrease their salaries, which could lead to lower prices and increasing international competitiveness • The problem is that wages and prices are rigid, especially in the short term. • For these reasons price flexibility (and labour mobility) can be an efficient adjustment mechanism in the medium and long term – People will not agree to change salaries if they are not sure that economic conditions have changed permanently • Nowadays in many sectors wages are not the main source of costs in companies

23. Price and wage flexibility as an alternative to thenominalexchangerateadjustment..? • Price and wage elasticity can be an efficient adjustment mechanism rather in the medium and long term – it is called the real exchange rate adjustment channel (instead of nominal) • The problem is that when nominal exchange rate change is needed, market forces lead to it - a country affected by a negative shock will usually experience currency depreciation. • So this change is not subject to negotiation. When you have to change prices and wages (as well as hire people), it can be difficult and tough. This is the main reason why this process is slow and costly

27. Financial market integration criterion • Countries sharing a single currency can mitigate the effects of asymmetric shocks among them through the diversification of their income sources, by adjusting their wealth portfolio, • through capital market - savings channel – diversification of assets before the shock (ex ante insurance) • through credit market- credit channel – shock absorption through access to a liquid financial market (ex post insurance) • The result of the discussion was the conclusion that similarity of shocks is not a strict prerequisite for sharing a single currency if all members of the currency area are financially integrated and hold claims on each other’s output

28. This channel can work when agents in both countries are able and willing to diversify their assets • In our case households in Spain buy Spanish and German car companies’ shares (the same in Germany) • In case of an asymmetric shock, Spaniards lose on Spanish shares but they compensate it through profits from German companies • Germans earn on German shares but lose money on Spanish ones. • In this way, financial market integration serves as an insurance system • Taking into account crisis experiences, we know that the ability of financial markets to smooth economic cycle differences between countries appeared weak.Moreover, financial market integration was the main cause of contagion

29. Fiscal and political integration • In our case (Germany vs Spain) increased tax revenue in Germany should be transferred to the common budget and furthered to Spain • Such a situation demands some form of political union and ability of central institutions to impose taxes in individual countries • Due to the lack of social and political integration the UE budget is very small and dedicated to functions other than stabilization

31. Nowadays we are discussing the future shape of fiscal policy and fiscal union but it is difficult to establish them when you are in crisis • As George Soros said, Europe was to be cooperation of equal countries but because of the crisis now it has become a confederation of debtors and creditors. • In such circumstances it is difficult to establish a level playing field. Insurance mechanisms should be established ex ante • Economic integration should be accompanied by political

33. Increasing role of fiscal policy in montery union

34. Factors which make countries less susceptible to shocks Meta property as a result of reconciliation phase “Symmetry” of shocks • Correlation of the business cycles(one monetary policy fits all) • Production diversification as well as similarity of economic structure (sectoral, supply, and demand distribution of the GDP, • Trade integration (The degree of economic openness – McKinnon 1963) ? • Similarity of inflation rates (Fleming 1971, Ishiyama 1975)

35. Trade openness • Openness of the economy is a special OCA property/measured by trade to GDP • First, in good times it is a channel through which the economy is tied to the rest of the monetary union and benefits from prosperity • Second, in bad times it is also a channel connecting one economy with the monetary union but in a negative way • Shock transmission depends on the degree of openness - Poland as an axample….and the most open countries as Ireland, Belgium

36. Trade openness Costs of abandoning monetary policy Trade/GDP -the more open the economy is, the more benefits can be achieved from the elimination of transaction costs (lower cost of monetary abandoning)

37. Usefulnessof exchange rate adjustment decreases with increased degree of openness. • Why is it so? • The more open the economy, the greater share of import input. • It means that when you depreciate/devalue your currency, it affects import prices and costs of external debt service (they increase) and with some lags leads to the general price increase • thatiswhyindebtedcountriesshould do not leave the euro ….

38. Diversification of production • In Mundell`s model we assumed two countries and one good which is traded across borders • In the reallity world this is more complex. A stable economy should not be dependent on one dominant activity. • If you have more diversified structure of your production and export, the probability of a severe shock is lower • A good example of monocultural production is Slovakia (about 50 % of its export production is concentrated on machinery equipment) as well as Spain and Ireland in the past when almost 20 % of their GDP was concentrated in the construction sector.

39. Similarityof inflation rates between countries • In the monetary union the issue of real exchange rate channel (measured by the level of prices and costs) becomes more important. This is the feature which relates to two important factors: • Similar rates of inflation prevent excessive shifts in price competitiveness among countries – lose of export market share • 2. This condition is rooted in Maastricht Treaty in price convergence criterion in order to avoid differences in real interest rates

41. After creating the monetary union the euro area has one nominal interest rate but in case of different inflation at national level real interest rates are diversified • Real interest rate = nominal interest rate – inflation • Due to higher inflation rates, peripheral countries experienced lending and consumption booms

42. The “Reconciliation Phase” - the 1970s • Slowing down of integration processes in Europe due to oil crisis and break up of Bretton Woods System • Assess balance of costs and benefits of monetary integration • The criteria have become more evident • The importance of the OCA properties have changed to some extent

43. Some observations on the “reconciliation phase” • Reconciliation strengthened the interpretation of some properties and led to diverse new insights such as the role of similarity of shocks – called “symmetry” meta property, because of its importance • Ishiyama points out that differences in inflation rates and wage flexibility are of the utmost importance • The usefulness of a common currency depends on the openness of the country, • Countries prone to shocks should cast an anchor in a more stable environment and import its monetary (anti-inflationary) credibility (McKinnon)

44. Some observations on the “reconciliation phase” • A new “meta-property” was advanced: i.e., the similarity of shocks -openness and similarity of shocks are also very important, • Mundell (1973) argues that if members of a currency area are financially integrated, a high similarity of shocks among them, although desirable, is no longer a strict prerequisite. • Mobility of factors of production and labour is highly desirable but also entails some costs and cannot effectively cope with disturbances in the very short-term. • For Ishiyama, similarity in price and wage inflation ranks the highest.

45. The “Reassessment Phase” the 1980s and early 1990s • When interest in European monetary integration re-emerged in the mid 1980s, economists looked back at the OCA theory, but could not find clear answers to the question whether Europe should proceed towards complete monetary integration. • At the end of this reassessment phase a “new” OCA theory starts emerging in relation to the “old” OCA theory (Tavlas (1993)).

46. The OCA changed owing to the reassesment: • of the Phillips Curve - neutrality of money in the longer term • the credibility issue (import credibility) • the importance of a nominal anchor, • The (in) effectiveness of exchange rate changes. • There are somewhat fewer costs in terms of the loss of autonomy of domestic macroeconomic policies • There are also more benefits, due to credibility gains, for countries with a track record of higher inflation (prior to adopting common currency)

48. The “Reassessment Phase”: the 1980s and Early 1990s • One of the main perceived costs of monetary integration is that member countries lose direct control over their national monetary policy. • This prevents them from undertaking business-cycle stabilisation: the cost that is represented by wider cyclical fluctuations is more severe when shocks are asymmetric However, monetarist critique of the short-term constant Phillips curve showed neutrality of money in the longer term, • It means that a change in the interest rates affects only nominal variables in the economy such as prices, wages and exchange rates, having no effect on real variables like GDP, employment and consumption • Hence, from this standpoint, the costs of losing direct control over national monetary policy are low.

49. The Credibility Issue (increases the role of stable and predictable macroeconomic policy) • The ability of a country to achieve and maintain low inflation is important while evaluating the costs of monetary integration. • Some governments could have an incentive to abandon a low inflation commitment that has been accepted at face value by the public in order to reduce unemployment along some short-run Phillips curve (Kydland and Prescott (1977) and Barro and Gordon (1983)). • Similarly, devaluations can also cause strong and long- lasting inflationary expectations

50. The Credibility Issue • For a country with a track record of relatively higher inflation and a reputation for breaking low inflation promises, a way to immediately gain a low-inflation credibility is to ‘tie its hands’ by forsaking national monetary sovereignty and establishing a complete monetary union with a low inflation country (Giavazzi and Giovannini (1989)) • Similarities of inflation rates could be a feasible outcome from participating in a monetary union but is not a necessary precondition (Gandolfo (1992) • This turns around one of the main OCA properties provided that the nominal anchor country can maintain the hegemony of the institutional setting that have preserved the low inflation environment (Tavlas (1993)).