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The Benefits of a Common Currency

The Benefits of a Common Currency. Introduction. The costs of EMU have mostly to do with macroeconomic management The benefits are mostly microeconomic in nature, i.e. they arise from efficiency gains of a monetary union. Sources of benefits. Less transactions costs Price transparency

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The Benefits of a Common Currency

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  1. The Benefits of a Common Currency

  2. Introduction • The costs of EMU have mostly to do with macroeconomic management • The benefits are mostly microeconomic in nature, • i.e. they arise from efficiency gains of a monetary union

  3. Sources of benefits • Less transactions costs • Price transparency • Less uncertainty • Benefits of an international currency • Does monetary union lead to more economic growth?

  4. Less transactions costs • Elimination of foreign exchange markets within union eliminates cost of exchanging one currency into another • Cost reductions amount to 0.25 to 0.5% of GDP (according to European Commission) • Full cost reduction only achieved when payments systems are fully integrated • TARGET payment system

  5. Price transparency • One common unit of account facilitates price comparisons • Consumers “shop around” more • Competition increases • Prices decline and consumers gain

  6. Will euro increase price transparency in a significant way? • Large price differentials continue to exist • These have to do with • transactions costs at the retail level • and product differentiation • See next tables

  7. Eurozone has not increased price convergence • Euro has not changed this • There is no evidence of price convergence • Euro may work indirectly by triggering further market integration in particular sectors, e.g. banking, insurance Source: Engel and Rogers (2004)

  8. The introduction of the euro and perceived price increases • A major surprise about the introduction of the euro is its unpopularity in a number of Southern countries. • Especially in Italy, but also in Greece, the introduction of the euro is associated with massive price increases.

  9. Possible explanation: • Low budget items, with low price elasticities • Competitive markets make it difficult to raise prices • Introduction of euro creates signal lowering the cost of collective action

  10. Less exchange risk • Euro eliminates exchange risk. Two issues: • Does the decline in exchange risk increase welfare? • Does the decline in exchange risk reduce systemic risk?

  11. Less exchange risk and welfare • Take individual firm under perfect competition Price uncertainty Price certainty P P MC MC F E P3 G B P1 P1 P2 C q q

  12. Profits are higher on average when there is price uncertainty • Welfare will then depend on degree of risk aversion • If risk aversion sufficiently high price certainty is preferred by firms • Model has a number of important assumptions • No adjustment costs • With sufficiently large price declines firm can go bankrupt; model assumes no bankrupcy costs

  13. Exchange rate uncertainty and the price mechanism • Large exchange variability reduces the quality of price signals in allocating resources • Example: large overvaluation of dollar in 1980s led to decline of export sector; a decline that turned out to be unnecessary once the dollar declined again. • These large real exchange rate cycles lead to large adjustment costs

  14. Benefits of an international currency • International use of the dollar creates seigniorage gains for the US • Similarly, if euro becomes an international currency, seigniorage gains will follow for Euroland • These gains, however, remain relatively small: • in the case of the US: less than 0.5% of GDP per year

  15. Benefits of monetary union and openness Benefits (% of GDP) Benefits of monetary union are likely to be larger for relatively open economies In absence of monetary union, transactions costs and exchange risk are larger for firms in very open economies Monetary union will be more beneficial for firms in very open economies Upward sloping benefit line Trade (% of GDP)

  16. Box 5: Fixing exchange rate and systemic risks Shocks in IS-curve: monetary union increases variability of output r LM F rf ISU IS ISL yL y’L y’U yU y

  17. Shocks in LM-curve Monetary union reduces variability of output LML r LM LMU G rf ISU IS ISL yL y yU y

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