Chapter 4:Costs and Benefits Compared

De Grauwe:Economics of Monetary Union

Costs and benefits of a monetary union

Benefits

CostsCo

sts

and

Ben

efit

s (%

GD

P)

Trade (% GDP)

Two views about costs and benefits of MU

Trade (% GDP) Trade (%GDP)

Cos

ts a

nd b

enef

its

Cos

ts a

nd b

enef

its

Benefits

Costs

Costs

Benefits

T* T*

(a) The monetarist view (b) The Keynesian view

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

• 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

• 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

Costs and benefits with decreasing rigidities

Cos

ts a

nd b

enef

its

Trade (% GDP)

T* T**

Benefits

Costs

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

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

Belgium/Luxembourg 66,7Slovakia 58,9Czech Republic 54,1Netherlands 51,1Estonia 45,6Hungary 43,7Slovenia 37,3Ireland 34,7Lithuania 30,1Austria 28,1Latvia 24,6Denkmark 23,1Poland 23,1Germany 22,0Sweden 21,2Malta 21,0Finland 19,1Portugal 16,6France 13,7Italy 12,2Spain 12,0United Kingdom 9,8Cyprus 6,1Greece 4,0

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

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

Asymmetric shocks and labour market flexibility in monetary unions

• Eurozone

• EU-25• USA

Sym

met

ry

Flexibility

•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

OCA

• 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

Costs and benefits in the long run

OCAT

T

Sym

met

ry

Trade integration

EU-25

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

EU-25

T´

T´

T

T

OCA

Sym

met

ry

Trade integration

The pessimistic view of monetary integration

Costs and benefits in the long run

• 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 T’T’ 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

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

The challenge of enlargement of EMU

• Two challenges– Enlargement poses problems for the 12 present

members– Enlargement poses problems for the newcomers

Is Euro-25 OCA? Openness as a criterion

0

10

20

30

40

50

60

70

80

CY

P

CZ

E

ES

T

HU

N

LV

A

LT

U

MA

L

PO

L

SV

K

SV

N

DK S

UK

AU

T

BE

L/L

UX

FIN

FR

A

DE

U

GR

C

IRL

ITA

NL

D

PR

T

ES

P

Countries

Exp

ort

s

Figure 4.11: Exports of goods and services towards EU-25 as percentage of GDP (2005)

• 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

Is Euro-25 OCA? Asymmetry of shocks

Correlation of demand and supply shocks with Euro area

GER

FRA

ITA

BEL

NLD

HUN

PRTAUTFIN

EST

S

DKESP

POL

IRLROM

GRSVK

UKSVNCZE

LVALTU

-0,6

-0,4

-0,2

0

0,2

0,4

0,6

0,8

-0,2 0 0,2 0,4 0,6 0,8

supply shocks

dem

and

sh

ock

s

•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

• 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

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

• 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

EU-25OCA

symmetry

Economic integration

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

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

80,0

Arg

entin

a

Bra

zil

Chi

le

Uru

guay

Par

agua

y

Bol

ivia

*

AU

T

BE

L/LU

X

DE

U

ES

P

FIN

FR

A

GR

C

IRL

ITA

NLD

PR

T

Countries

Exp

ort

s

Figure 4.16: Intraregional exports of goods and services, EU and Latin America as a percentage of GDP (2005)

– 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

Is East-Asia an optimal currency area?

Interregional exports of goods and services, East-Asia and EU

as % of GDP (2003)

0

10

20

30

40

50

60

70

80

90

100

CH

INA

HK

KO

R

MA

L

PH

IL

TH

AI

SIN

AU

T

BE

L/LUX

FIN

FR

A

DE

U

GR

C

IRL

ITA

NLD

PR

T

ES

P

exp

ort

s

135

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.

Shocks are not more asymmetric in Asia than in Eurozone

Percent of demand and supply changes explained by common shock

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

China

Hong K

ong

Indo

nesia

Japa

n

Korea

Mala

ysia

Philipp

ines

Singap

ore

Taiwan

Thaila

nd

a

vera

ge

per

cen

t co

mm

on

sh

ock

supply

demand

Percent of demand and supply changes explained by common shock

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Austri

a

Belgium

Finlan

d

Franc

e

Germ

any

Greec

e

Irelan

dIta

ly

Nether

lands

Portu

gal

Spain

a

vera

ge

per

cen

t co

mm

on

sh

ock

supply

demand

Asia

Eurozone

• 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

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?

Figure 4.20: Intraregional exports of goods and services in West-Africa (2003) and the Eurozone (2005)

0

10

20

30

40

50

60

70

80

Benin

Burk

ina F

aso

Cape V

erd

e

Côte

d'Iv

oire

Gam

bia

, T

he

Ghana

Guin

ea

Guin

ea-B

issau

Lib

eria

Mali

Nig

er

Nig

eria

Senegal

Sie

rra L

eone

Togo

AU

T

BE

L/L

UX

DE

U

ES

P

FIN

FR

A

GR

C

IRL

ITA

NLD

PR

T

• 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

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

• 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