Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 12 Optimum Currency Areas Theory and Politics of Eropean Integration.

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1 Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 12 Optimum Currency Areas Theory and Politics of Eropean Integration

2 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Last Lecture A monetary history of Europe ·Metallic money ·Monetary equilibrium under gold standard (Hume’s mechanism) ·The interwar period ·The post-war period: ·From Bretton Woods to Snake and Super-Snake to EMU The choice of exchange regimes ·Exchange rate and monetary policy ·The range of exchange rate policies ·Choices –Criteria –Fix or float? –Regional arrangements

3 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas This lecture Leftovers from the last lecture Choice of exchange rate regimes Optimal currency areas Theory ·Adjustment under asymmetric shocks ·With and without currency union Six criteria for OCA Do the members of the Eurozone fullfill criteria for optimal OCA?

4 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Long term neutrality implication: PPP The real exchange rate Defined as = EP/P* E = nominal exchange rate; P = domnestic price; P* = foeign price Purchasing Power Parity (PPP): E offsets changes in P/P* So is constant Many caveats, though: PPP seems to hold in the long run, but not in the short and medium run

5 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Short term non-neutrality of money From AD-AS: the short-run AS schedule So monetary policy matters in the short run Channels of monetary policy The interest rate channel The credit channel The stock market channel The exchange rate channel

6 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) foreign level interest rate

7 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level interest rate 1. increase in money supply moves LM to LM‘, 2. interst rates declines initially to B, 3. spending expands and economy moves to C 4. capital flows out until interest rate is back to international level

8 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level interest rate Flexible exchange rate: currency depreciates current account improves (IS shifts to IS‘) output moves eventually to D

9 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ output-gap (Actual-Trend GDP) Foreign level interest rate Fixed exchange rate: Central Bank must intervene in exchange market money supply shrinks until LM curve shifts back from LM‘ to LM and output to A

10 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ output-gap (Actual-Trend GDP) Foreign level interest rate Thus, there is no room for monetary policy with a fixed exchange rate!

11 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level interest rate

12 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level 1.Fiscal policy shifts IS curve to IS’. 2.LM stays where it is. 3.Output moves to B. 4.The interest rate rises above foreign level. 5.Capital flows in to restore interest parity interest rate

13 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Fixed exchange rate: Central Bank intervenes to prevent currency appreciation sells money such that increased money supply shifts LM to LM’ economy moves eventually to point C interest rate

14 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Flexible exchange rate: Capital flows in and currency appreciates Current account worsens Demand declines Eventually, IS’ shifts back to IS and the economy back to A interest rate

15 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Thus, fiscal policy does only work under fixed exchange rates in small open economnies interest rate

16 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Exchange rate regimes and policy effectiveness Monetary policy Fiscal policy Fixed exchange rate IneffectiveEffective Flexible exchange rate EffectiveIneffective

17 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas When does the regime matter? In the short run, changes in E are mirrored in changes in = EP/P*: P and P* are sticky In the long run, is independent of E: P adjusts If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy Put differently, the choice of an exchange rate regime has mostly short run effects because prices are sticky

18 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas What’s on the menu? Free floating (e.g. US, Eurozone) Managed floating (e.g. Japan) Target zones (e.g. ‘snake’) Crawling pegs (e.g. Poland under transition) Fixed and adjustable (e.g. Bretton Woods) Currency boards (e.g. Estonia, Lithuania in 1990s) Dollarization/Euroization Monetary union

19 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas The choice of an exchange rate regime The monetary policy instrument Can be useful to deal with cyclical disturbances Can be misused (inflation) The fiscal policy instrument Can also deal with cycles but is often politicized Can be misused (public debts, political cycles) Exchange rate stability Freely floating exchange rates move “too much” Fixed exchange rates eventually become misaligned

20 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas The old debate: fixed vs. float The case for flexible rates With sticky prices, need exchange rate flexibility to deal with shocks Remove the exchange rate from politicization Monetary policy is too useful to be jettisoned The case for fixed rates Flexible rates move too much (financial markets are often hectic) Exchange rate volatility: a source of uncertainty A way of disciplining monetary policy In presence of shocks, always possible to realign

21 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas The new debate: the two-corners solution Only pure floats or hard pegs are robust Intermediate arrangements (soft pegs) invite government manipulations, over or under valuations and speculative attacks Pure floats remove the exchange rate from the policy domain Hard pegs are unassailable (well, until Argentina’s currency board collapsed…) In line with theory Soft pegs are half-hearted monetary policy commitments, so they ultimately fail

22 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas The two-corners solution and the real world Fear of floating Many countries officially float but in fact intervene quite a bit Fear of fixing Many countries declare a peg but let the exchange rate move out of official bounds

23 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Fear of floating

24 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas The two-corners solution and the real world Fear of floating is deeply ingrained in many European countries Fear of fixing partly explains the disenchantment with the EMS and some reluctance towards monetary union

25 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Conclusions A menu hard to pick from: trade-offs are everywhere All of this takes the view from a single country Systems involve many countries and rest on agreed upon rules, including mutual support Since the end of Bretton Woods, there is no world monetary system This leaves room for regional monetary systems. Enters Europe’s experience

26 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Optimal currency areas (OCA)

27 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas A good question, no simple answer Should curreny area borders coincide with national borders? If not, how best to delineate currency areas? What economic criteria should be used?

28 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas The economic toolkit There must be benefits and costs involved in adopting a common currency The solution has to involve trading off these benefits

29 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas In a nutshell The benefits Money exhibits increasing returns to scale (network externalities) The world is the way to maximize these benefits The costs Loss of monetary and exchange rate instruments Matters in presence of: ·Price and wage stickiness ·Asymmetric shocks

30 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Focusing on costs Start with the idea that benefits argue for one worldwide currency Ask why not Look at the costs No precise way of estimating costs and benefits so, in the end, a matter of judgement Look at asymmetric costs How they create trouble What makes them more likely What makes them less painful

31 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help?

32 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help? If domestic prices and wages are sticky, adverse demand shock will reduce production to C if exchange rate does not adjust

33 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks Simplest example: an adverse demand shock: how can the exchange rate help? If exchange rate adjusts, production declines to D.

34 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU

35 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU No currency union case: Real exchange rate declines in country A to λ 1, production declines to B, country B remains unaffected

36 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU Currency union case: Central Bank let currency decline to λ 2, production declines in country A to C, increases in country B to D‘

37 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU This creates inflationary pressures in B (difference between D and D’). Eventually, after wage and price adjustment, country A will move to B and country B to A

38 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Implications of asymmetric shocks Thus, both countries are hurt when they share the same currency Also the case when a symmetric shock creates asymmetric effects This is an unavoidable cost of a currency area

39 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Six critieria for a optimal currency area Next questions: What reduces the incidence of asymmetric shocks? What makes it easier to cope with shocks when they occur The analysis develops six criteria for an optimal currency area (OCA) Three economic ·labour mobility ·diversion ·trade openness Three political ·transfers ·homogeneous preferences ·Common destiny

40 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Criterion 1 (Mundell): Labour mobility In an OCA labour moves easily across national borders. Caveats Labour mobility is easy within national borders (culture, language, legislation, welfare, etc…), but much less so across national borders Capital mobility: difference between financial and physical capital In case of country specialization, skills also matter and hinder labour mobility

41 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Criterion 2 (Kenen): Production diversification Countries whose production and exports are widely diversified and of similar structure form an OCA. Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern

42 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Criterion 3 (McKinnon): Openness Countries which are very open to trade and trade heavily with each other form an OCA. Distinguish between traded and non-traded goods Traded good prices are set worldwide A small economy is price-taker, so the exchange rate does not affect competitiveness In the limit, if all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness

43 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Criterion 4: Fiscal transfers Countries that agree to compensate each other for adverse shock form an OCA. Transfers can act as an insurance that mitigates the costs of an asymmetric shock Transfers exist within national borders Implicitly through the welfare system Explicitly in federal states

44 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Criterion 5: Homogeneous preferences Countries that share a wide consensus on the way to deal with shocks form an OCA. Matters primarily for symmetric shocks Prevalent when the Kenen criterion is satisfied May also help for asymmetric shocks Better understanding of partners’ actions Encourages transfers

45 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Criterion 6: Commonality of destiny Countries that view themselves as sharing a common destiny better accept the costs of operating an OCA. A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interests This calls for accepting such economic costs in the name of a higher purpose

46 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Is Europe an OCA? A synthetic OCA index: How much of a currency appreciation/ devaluation vis-à-vis the DM is needed to keep economic conditions unchanged?

47 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Is Europe an OCA? Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate

48 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Openness Most EU countries are very open: The McKinnon criterion is broadly satisfied

49 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Diversification Most EU countries have a diversified production structure (intra-industry trade dominates) The Kenen criterion is broadly satisfied and well explains which countries joined the euro area

50 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Labour mobility (1) The labour mobility criterion cannot be black-and-white The migration response to economic incentives must consider many costs: Moving costs Risk of becoming unemployed Longer run career opportunities Family prospects Eligibility to welfare Taxation Cultural/linguistic differences National attachment

51 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Labour mobility (2) An international comparison suggests that labour mobility is low in Europe Across countries

52 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Labour mobility (2) An international comparison suggests that labour mobility is low in Europe Across countries Even within countries

53 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Labour mobility (3) Low labour mobility implies that unemployment bears much of the burden of adjustment to shocks An US-EU comparison

54 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Transfers The EU does not satisfy the transfer criterion The overall EU budget is low, capped at 1.27% of EU GDP entirely used for administration, CAP, regional and structural funds These funds do not vary with the business cycle and are not earmarked to address asymmetric shocks

55 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Homogeneity of preferences Preferences could affect the role of monetary and fiscal policies to address external shocks Little is known about this criterion

56 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Commonality of destiny Little is known about this criterion Public opinion polls do not reveal deep opposition to EU institutions

57 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Overall The OCA glass is half full, or half empty

58 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas History never ends: the endogeneity of OCA criteria Living in a monetary union may help fulfill the OCA criteria over time Would the US be an OCA without a single common currency? Will the existence of the EURO area change matters too ?

59 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Will trade deepen? Little evidence that reducing exchange rate volatiliy increases trade Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot Estimates range from 50% to 100% The “border effect” provides similar estimates

60 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Will diversification grow or decline? Argument 1: intra-industry trade will grow Argument 2: specialization will increase No firm conclusion so far

61 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas EMU and labour markets Mobility may not change much, but wages could become less sticky Two views: The virtuous circle: labour markets respond to enhanced competition by becoming more flexible The hardening view: labour markets respond to enhanced competition by increasing protective measures that raise stickiness The jury is still out

62 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Are the other criteria endogenous? Transfers Currently no support for more taxes fo finance transfers Homogeneity of preferences No presumption that it will change soon Commonality of destiny No presumption that it will change soon

63 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas In the end Monetary union is not only about economics The OCA criteria do not send a clear signal The EU is not a perfect OCA A monetary union may function, at cost The OCA criteria tell us where the costs will arise: Labour markets and unemployment Political tensions in presence of deep asymmetric shocks

64 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | herbert.bruecker@uni-bamberg.de | www.uni-bamberg.de/sowi/bruecker Theory and Politics of European Integration Optimal Currency Areas Next lecture European Monetary Union (EMU) Reading: Baldwin/Wyplosz (2009), Chs. 17-18 Discussion of exam