international finance 120181-1165 the optimum currency area theory

International finance 120181-1165

The optimum currency area theory


Lecture outline

The Mundell, McKinnon and Kenen models

The „new” OCA theory

The comparative approach

The endogeneity of OCA


The Mundell model

Assumptions

two countries

full employment

BP in equilibrium

short term price and wage rigidity


The Mundell model

Demand shock analysis

Two cases: different currencies in two countries

currency union


The Mundell model

Demand increases for country A products

Demand decreases for country B products

Inflationary pressures in country A,

unemployment growth in country B

If countries use separate currencies ER

adjustments


The Mundell model

In case of a currency union: Expansionary monetary policy in country B

causes inflationary pressures in country A

Worsening of terms of trade in country A

versus country B

The need to adjust demand shocks by other

means than ER- labour force mobility


The Mundell model

Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000


Modifying assumptions

Modifying the assumption of price and

wage rigidity new adjustment

instruments

Labour market flexibility


Adjustment through prices and wages changes

Source: Own elaboration based on: J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000


Conlusions from the Mundell model

If two economies characterized by price

and wage rigidity want to introduce a

currency union they should ensure labour

force mobility


The McKinnon model

The comparison of the utility of two instruments

reinstating the external equilibrium depending on

the openness of the economy : Flexible ER

Internal monetary and fiscal policy

The openness of the economy – the ratio of

tradable and nontradable products in the

production and consumption structure


The McKinnon model

Assumptions:Two economies - different openness

No factor mobility


The McKinnon model

An open economy Flexible ER as a mean of maintaining the

external equilibrium

Growing demand for tradables current

account deficit


The McKinnon model

Devaluation price increase of the imported

goods vs. nontradables supply growth of

tradables and demand growth for nontradables

BP equilibrium reinstated

but

the tradables price increase is permanent


The McKinnon model

External equilibrium reinstatement by

contractionary fiscal policy

Influence on employment???

The effect of BP improvement outperforms the

effect of employment reduction depending on

the grade of openness


The McKinnon model

A less open economy

Demand grows for tradables current account

deficit

Devaluation price increase of the imported

goods vs. nontradables supply growth of

tradables and demand growth for nontradables

BP equilibrium reinstated


The McKinnon model

Contractionary fiscal policy the

influence mostly on the nontradables

sector

High share of nontradables

unemployment increase


The McKinnon model

Source: Own elaboration based on: K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006

Y

PAD’

KW x P

AD

AS

C

BA

Y

P

AD’AD

AS

AD’’


Conclusions from the McKinnon model

The higher the grade of openness of

economy the lower is the efficiency of a

flexible ER as an adjustment tool and the

higher is its negative influence on price

stability


The Kenen model

Assumptions: Two economies with different production structure

diversification

Factor mobility

Demand shocks analysis


The Kenen model

Demand shock internal equilibrium

exacerbated

The effect on external balance depends

on the grade of diversification

Higher diversification shocks concern

only a part of the production/exports


Conclusions from the Kenen model

Countries can create a currency union

provided a diversified export structure is

ensured

An economy with higher production

diversification does not have to use the ER

as adjustment tool as often as a less

diversified economy


The optimalisation criteria deriving from the „old” theory

factor mobility

labour market flexibility

the openness of the economy

production diversification


The drawbacks of the „old” theory

Rigid prices assumption

Demand side approach

The only cost of monetary integration is the loss

of ER as adjustment instrument

Consideration of the cost of monetary

integration, the advantages are neglected


„The „new” OCA theory

Keynesian assumptions rejected

Ingram (1969)- integration of financial markets

Haberler (1970) and Fleming (1971)- inflation rates

similarity

Corden (1972) and Giersch (1973)- inflation preferences

similarity


Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,


Opracowanie własne na podstawie P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,


The Barro-Gordon model

Monetary policy credibility analysis after

establishing a monetary union

Rational inflation expectations

U-Un=α(Лe-Л)



Different preferences concerning the restrictiveness of the

monetary policy

In one of the countries the CB is not credible the inflation

target is not fulfilled

Rational expectations price increase

Currency union there is only one common inflation level set by

a supranational CB



Source: Own elaboration based on: P. De Grauwe, Economics of monetary union, Oxford University Press, Oxford 2003,


Coclusions from the Barro-Gordon model

The establishment of a currency union may influence

positively the credibility of the monetary policy of a

country, which previously led an inefficient monetary

policy

The condition: the supranational CB conducts a

monetary policy designed as the policy of the country

with the lowest inflation


The advantages of creating a monetary

union Creating a monetary union monetary credibility

increase and the decrease of risk premium+ ER risk

elimination

A single decrease of the risk premium contributes to

production growth

Learning effects, effects of scale and additional capital

accumulation potential increase of productivity in the

long term


The advantages of creating a monetary union

Source: Own elaboration based on: de Grauwe, op. cit

F (k)

F’ (k)

C

B

A

y

k

r’

r

r”


The comparative OCA approach

Assessing the gains and losses related to

monetary unification

The Keynesian and monetarist approach

The extent of gains and losses depends

on the assessment of the ER efficiency as

adjustment tool



Source: Own elaboration based on: de Grauwe, op.cit.



Krugman’s approach vs. European

Commission’s approach

The symmetry of shocks as optimalisation

criterion

The influence of trade integration on the

symmetry of shocks



The influence of trade integration on the

assymetry of shocks

Countries which do not fulfill the OCA criteria ex

ante may fulfill them ex psot

Empirical evidence Bayoumi and Eichengreen

(1996), Frankel and Rose (1996)



One can not assess the fulfilment of the OCA criteria on

the base of historical data

Endogenous processes within currency unions

Positive correlation between trade intensity and

business cycle correlation


Source: Own elaboration based on: F. Mongelli, „New“ views on the optimum currency area theory: what is EMU telling us?, ECB Working Paper no. 138, ECB, Frankfurt am Main 2002,



Summing up

Some of the OCA criteria: Factor mobility

Labour market flexibility

The openness of the economy

Production diversification

Symmetry of shocks

Financial integration

Similarity of inflation levels


Summing up

„The old” and „the new” OCA theory

The assesmesnt of the ER efficiency as

an economic policy tool

The comparative approach- Krugman vs.

EC



References

A. Alesina, R. Barro, Currency unions, Quarterly journal of Economics, 2002

T. Bayoumi, The formal model of optimum currency areas, IMF Staff Papers, vol. 41, 1994,

T. Bayoumi, B. Eichengreen, Ever closer to heaven? An optimum currency area index for European countries, European Economic Review no.41, 1997

J. Borowski, Polska i UGW: optymalny obszar walutowy?, Materiały i Studia nr 115, NBP, Warszawa 2000

J. Frankel, A. Rose, The endogeneity of the optimum currency area criteria, NBER Working Paper, Cambridge 1996


References

P. De Grauwe, Economics of monetary union, Oxford University Press, 2007.

P. Kenen, The theory of optimum currency areas: an eclectic view w: Monetary problems of the international economy, The University of Chicago Press, Chicago & London 1969

R. McKinnon, Optimum currency areas, The American Economic Review vol. 53, 1963

R. Mundell, A theory of optimum currency areas, The American Economic Review vol. 51, 1961

K. Rose, K. Sauernheimer, Theorie der Außenwirtschaft, München 2006

international finance 120181-1165 the optimum currency area theory

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