WEEK 9 - Optimum Currency Area and Euro Zone

Question 1

What are the dif bodies of the EU?

Answer 1

1. European Parliament: elected by citizens of member countries
2. Council of the European Union: appointed by governments of the
   member countries
3. European Commission: executive body
4. Court of Justice: interprets EU law
5. European Central Bank, which conducts monetary policy through a system of member country banks called the European System of Central Banks

Question 2

What is the EMS?

Answer 2

• > originally a system of Fixed exchange rates implemented in 1979 through an exchange rate mechanism (ERM).
• > Has developed to Econ and Monetary Union (EMU)
  - Replacing exchange rate mechanism for common currency
  - System of co-ordinated econ and monetary policies

Question 3

What are the conditions of joining the EMU?

Answer 3

1. adhere to the ERM: exchange rates were fixed in specified bands
   around a target exchange rate.
2. follow restrained Fiscal and monetary policies as determined by Council of the European Union and the European Central Bank.
3. replace the national currency with the euro,

Question 4

What are some of the conditions for joining the EU?

Answer 4

1. have low barriers that limit trade and Flows of Financial assets
   2 adopt common rules for emigration and immigration to ease the movement of people
   3 establish common workplace safety and consumer protection rules
   4 establish certain political and legal institutions that are consistent with the EU definition of liberal democracy

Question 5

What was the purpose of establishing the EU and the ERM/EMU?

Answer 5

1. To enhance Europe power in international affairs
2. To make Europe a unified market
3. To make Europe politically stable and peaceful

Question 6

Why did EU members adopt the Euro?

Answer 6

1. Unified market: the belief that greater market integration and economic growth would occur.
2. Political stability: the belief that a common currency would make political interests more uniform.
3. The belief that German influence under the EMS would be moderated under a European System of Central Banks.
4. Elimination of the possibility of devaluations/ revaluations:

Question 7

What occurs when two countries form a monetary union an asymmetric shock in demand occurs?

Answer 7

Assume both Ger and Fr union

• > Decline in aggregate demand in France
• > Increase in aggregate demand in Germany.
• > assumed permanent

SEE GRAPH IN NOTES

Question 8

What can we see with some of the downsides of the monetary union?

Answer 8

Using again Fr and Ger, can see that in union:

->France cannot stimulate demand using monetary policy; nor can Germany restrict aggregate demand using monetary policy.

Question 9

What are some of the alternatives to stimulate demand in monetary union?

Answer 9

• Wage Flexibility

- Labour Mobility

Question 10

What happens under Wage Flexibility?

Answer 10

• AS in Fr shifts downwards
• AS in Ger shifts upwards

SEE GRAPH IN NOTES

Question 11

Why is Labour Mobility limited in Europe?

Answer 11

Due to social security systems

-> Especially for low skilled workers

Question 12

When will a Monetary Union be costly?

Answer 12

• > Wages and Prcies are not flexible

- > Labour is not mobile

Question 13

What happens if countries in a monetary union maintain their own currency and national central bank?

Answer 13

Then national interest rate and/or exchange rate can be used by the respective authorities to address the asymmetric shocks.
-> France can pursue an expansionary monetary policy while Germany
adopts a contractionary monetary policy.

SEE GRAPH IN NOTES

Question 14

When does the OCA claim a monetary union is optimal?

Answer 14

If one of the following conditions satisfied:

1. Sufficient Wage Flexibility
2. Sufficient Mobility of Labour

Question 15

What is another implication of losing monetary independence in joining a monetary union?

Answer 15

• > Fundamentally changes the capacity of governments to finance their budget deficits.
• > Members of monetary union issue debt in currency over which they have no control.
• > Financial markets acquire power to force default on these countries

This doesn’t happen in countries that are stand alone and issue debt in their own currency

Question 16

Why does being a stand alone country benefit in terms of budget financing? USING UK AS AN EXAMPLE

Answer 16

1. Suppose investors fear default of UK govt
2. Investors sell UK govt bonds (yields increase)
3. Leads to sterling depreciation
4. UK money stock stays the same (liquidity stays the same) if not BoE can buy UK govt bonds

Thus, investors cannot force a liquidity crisis and thus not force a default (BoE superior force) so investors don’t try

Question 17

Why does being a stand alone country benefit in terms of budget financing? (USING SPAIN AS AN EXAMPLE TO SHOW THE OPPOSITE)

Answer 17

1. Suppose investors fear default of Spanish Govt
2. Investors sell Spanish bonds (Yields increase)
3. Leads to investors investing in other eurozone assets
4. No FOREX mkt and floating exchange to stop this
5. SP money stock declines, pool of liquidity for investing decreases
6. No Spanish CB that can buy back bonds -> Liquidity crisis possible and so default possible

Investors know this and will tempted to try

Question 18

What happens if a monetary union is fragile?

Answer 18

• When investors distrust particular member govt they will sell bonds, raising interest and triggering liquidity crisis
• Which may set solvency problem
• With higher interest, govt debt burden up, forcing govt to reduce spending and increase tax
• Forcing budget austerity and in turn may lead to stopping servicing the debt and declaring a default

Question 19

What is solution of a fragile monetary union?

Answer 19

-> A monetary union with a budgetary union

Budgetary Union:
Centralising part of the national budgets into common union budget

Question 20

What does a budgetary union achieve?

Answer 20

1. Creates an insurance mechanism triggering income transfers from the
   country experiencing good times to the countries hit by bad luck.
   2 Allows consolidating a significant part or national
   government debts and deficits thereby protecting its members from
   liquidity crises and forced defaults

Question 21

What are the 3 basic critiques of the OCA theory?

Answer 21

1. How relevant are the differences between countries? Should we worry?
2. Is national monetary policy (including exchange rate policy) effective?
3. `How credible are national monetary policies?

Question 22

What are the two views into how likely are asymmetric shocks when integration increases?

Answer 22

Optimistic View:
Intra-industry trade leads to similar specialisation patterns
Integration leads to more equal econ structures and less asymmetric shocks

Pessimistic View
Econ of scale lead to agglomeration effects and clustering
Integration leads to more asymmetric shocks

Question 23

Why do divergences in growth lead to adjustment problems?

Answer 23

Countries that have lost competitiveness will have to reduce their
wage levels relative to the other countries of the Eurozone (if they
cannot raise productivity).

->likely to be a slow and painful process without union, they could just devalue and bring back competitiveness

Question 24

What does the Balassa Samuelson effect argue?

Answer 24

Productivity in countries vary leading to deviations on its PPP -> Only difference between countries is the wage differential -> Wage inflation represents productivity

Therefore, difference between 2 states is productivity

SEE MATHEMATICAL DERIVATION IN NOTES

Question 25

What does the Barro-Gordon model explain?

Answer 25

Using phillips curves and indifference curves uses it to explain differing govt pressures

Question 26

What does a Wet nosed govt and a wet govt look like under the Barro-Gordon model?

Answer 26

Hard Nosed:
Cares more about inflation than unemployment

Wet Govt
Opposite

-> Under a hard nosed govt, lower inflation can be achieved without more unemployment in LR,

since all rational agents will prefer B to A and set expectations such that Govts no longer have incentive from interest
->Shown in Point E

SEE GRAPH IN NOTES

Question 27

In the Barro-Gordon model what happens when we add the PPP to link inflation rates of 2 countries?

Answer 27

Using Ger and Italy

e = Pi - Pg

Question 28

Why does simply fixing the currency to another not work?

Answer 28

Fixing the exchange rates of the lira with the mark, not credible -> Italian authorities have incentive for surprise inflation (Devaluation)

Question 29

What is the only way a country can escape from high inflation equlibrium?

Answer 29

By abolishing their currency in favour for the currency they were going to fix to

(WHAT THOSE WHO DOLLARISE OR EUROIZE AIM TO DO)

Question 30

Why is Monetary Union more complicated than dollarising or fixing the currency?

Answer 30

-> New central bank may not have the same rep as the initial central bank so the latter is reluctant to join

Question 31

What does the Optimal Stabilisation and Monetary Union graph show?

Answer 31

Dotted line is Optimal Stabilisation line

• Without stabilisation unemployment drop to B’ after shock
• With stabilisation, increase in unemployment limited to B
• Price paid is higher inflation
• Price increase with steepness of stabilisation line

SEE GRAPH IN NOTES (SEE LECTURE NOTES)

Question 32

Optimal stabilisation in country with low preference for unemployment stability?

Answer 32

SEE GRAPH IN NOTES (SEE LECTURE NOTES)

-If country cares less about unemployment -> Same shock lead to stronger increase in unemployment but less inflation

Question 33

Why is the Eurozone an incomplete monetary union?

Answer 33

Monetary union really means moving towards
more political union
-> Requires some transfer of sovereignty from national to supranational institutions

Question 34

What would have happened if the eurozone became the United States of Europe?

Answer 34

->fragility would disappear.

Question 35

How do we create a more unified EU (for monetary union)?

Answer 35

Needing a deep variable (strong national sense of common purpose and
an intense feeling of belonging to the same nation)
-> policy of small steps that create a governance structure that helps
to make the monetary union more sustainable is possible.

Question 36

What are some of the small steps that create a governance structure in the EU?

Answer 36

1 Coordination failures
2 Collective action: at the level of the central banks and the other at
the level of the governments to deal with crisis situations and to
structurally strengthen the union.
3 The role of the central bank: lender of last resort.
4 Consolidating Government budget and debts.
5 A Strategy of small steps: the joint issue of common bonds.
6 Coordination of budgetary and economic policies