5a: Downsides of a Monetary Union

Question 1

Overview on Downsides

Answer 1

Monetary integration happens through the replacement of the national currencies by the introduction of a new common currency of the participating countries under a common central bank.

Nations are no longer able to

• devalue or revalue their currency.
• determine the quantity of the national money in circulation.
• change the short-term interest rate

As a result countries may face

• costs of asymmetric shocks
• costs of symmetric shocks

Question 2

Sources of Asymmetries Between Countries

Answer 2

Different preferences about inflation and unemployment:

• Different preferences about inflation and unemployment create potential cost of monetary union
• This analysis holds only if short-term Philips curve is stable

Different labour Market institutions:

• Centralized versus non-centralized wage bargaining
• Symmetric shocks (e.g. oil shocks) are transmitted differently if institutions differ across countries

Different legal systems:

• All three factors to different transmission of symmetric shocks (e.g. interest rate change)
• Anglo-Saxon versus continental European financial Markets

Question 3

Symmetric vs Asymmetric Shocks

Answer 3

When shocks are asymmetric:

• Monetary union creates costs compared to monetary independence
• Common central bank cannot deal with these shocks

When shocks are symmetric:

• Monetary union becomes more attractive compared to monetary independence
• Common central bank can deal with these shocks
• Monetary independence can then lead to conflicts and ‘beggar-my-neighbour’ policies

Question 4

Summary on Shocks

Answer 4

Given the occurrence of asymmetric shocks and various rigidities:

• Monetary union will be costly, if
• wages and prices are not flexible
• labour is not mobile
• Monetary union may be more costly than remaining independent.

However, analysis is incomplete

• Cost of monetary union can be reduced by insurance mechanisms which might alleviate the pain of countries hit by negative shocks.
• There are several ways to achieve this.

Question 5

Insurance Against Asymmetric Shocks

Answer 5

Insurance against asymmetric shocks can be organized - that is: a transfer of income from Germany to France if budgets were to be centralized.

Public insurance systems: automatic transfers from high income regions to low income regions

This automatic fiscal policy dampens the local decline in net income (e.g. German “Länderfinanzausgleich”)

In the EMU there is no such fiscal counterbalance to local swings in domestic demand

Members can vary national spending:

• Automatic stabilizers – deficit in FR increases, decreases in GER
• primary effect of any country’s fiscal deficit is diluted and spread over the entire currency union

Question 6

Other Forms of Insurance

Answer 6

• Flexible national budgets: France allows deficit to accumulate and Germany allows surplus
• Private Insurance schemes: Insurance through financial markets. If financial markets were perfectly open, shocks could be eased by reciprocal stock/bond holdings.

Question 7

Does Growth Matter?

Answer 7

Fast growing economies do not incur higher costs:

• In fast growing countries income elasticities are typically higher.
• Fast growing countries tend to have a higher productivity of capital than low growing economies Might even be better off: With the risk of uncertainty gone, investors from slowly growing areas might find it beneficial to invest thus leading to more technology
• New Trade Theory: Intra-sectoral investment may lead to a synchronization of business cycles.