Transcript Optimum Currency Areas

Optimum Currency Areas
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Optimum Currency Areas
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A theoretical construct,
no country
conforms to the ideal but the US
with high labor and capital mobility
comes much closer to the ideal
than Europe.
In a currency area (with one single
currency), asymmetric economic
shocks are dealt with through the
internal redeployment of resources
rather than currency realignments.
Optimum Currency Areas II
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Example from the US: the rise in the price of oil in the 70s
affected Texas differently than the Midwest (Asymmetric effect
of external shocks).
Energy-poor Midwest: output fell and
unemployment rose. Energy-rich Texas: high oil prices raised
output and employment of the oil producers and increased energy
production.
In an open and flexible economy such as the US;
a) with high level of labor and capital mobility: Unemployed
Midwest workers migrated to Texas in search of employment
while capital flowed to Texas to finance construction and
investment. Overtime, a new equilibrium with converging
unemployment and wage levels were established in Texas and
Midwest (labor costs fell in Midwest and rose in Texas).
b) with fiscal federalism in the US: Existence of a unified
federal budget acts as an automatic economic stabilizer that
counters recessions in lagging regions and somewhat dampens
economic activity in booming regions, thereby smoothing out
economic imbalances in two different regions. For example: If
Midwest is in recession, amount of federal taxes paid in this
region falls automatically while payments from DC to
Midwesterners for unemployment insurance and welfare increase.
If California is experiencing a boom at the same time, its tax
payments to the federal treasury rise and receipts from DC in
the form of unemployment insurance etc. falls.
Optimum Currency Areas III
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In either case, the federal budget in
the US dampens disparities between
regions.
The counter-cyclical effects of the
federal
budget
offset
somewhere
between 20 and 40 percent of
differences in economic performance in
the US.
Other federal systems like Germany:
Within Germany, states make direct
transfers to each other and less
adjustment is left to the automatic
workings of income taxes and benefit
programs.
Optimum Currency Areas IV
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A unified fiscal system must exist alongside a
single currency and a centrally operated
monetary policy for EMU to work.
Before the single currency, an asymmetric
shock with a preference shift towards German
products away from French products would be
handled
through
currency
realignments.
Germany experiencing a demand boost would
generate a trade surplus and an appreciation of
DM. Whereas France experiencing a fall in
demand would generate a trade deficit and a
depreciation of FF. (ASSUMPTION: No wage
flexibility or labor mobility in France and
Germany Need for exchange rate parity
changes to correct for the effects of
asymmetric shocks).
Optimum Currency Areas
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Case with wage flexibility and labor mobility
within Germany and France. There may be no
need for a currency realignment.
If wage flexibility, fall in demand for French
products leads to a decline in wages in France
(how likely is this given the observed downward
rigidity of wages), increasing supply of French
products, reducing their prices and making
French goods more competitive. Hence, French
trade deficit may be reduced. Germany by
contrast experiences an increase in wages,
which shifts its supply to the left creating
inflation and loss of competitiveness for
German products, eventually reducing the size
of its trade surplus. End result: Less need for
a currency realignment for FF and DM parity.
Optimum Currency Areas
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If labor mobility exists between Germany and France,
then unemployed workers in France can relocate to
Germany. No need to pay unemployment benefits in
France (budget deficit does not have to increase in
France) and trade deficit need not increase.
If none of these two factors work, then France suffers
from unemployment and twin deficits (in government
budget and trade account) while Germany suffers from
inflation and experiences a trade surplus. Pressure on
FF for a depreciation and on DM for an appreciation.
Exchange rate alignments solve these problems
remarkably well.
But this is no longer an option under single currency.
As long as such asymmetric shocks affect the economies
of the Union, there exists a case for a) increasing labor
mobility and b) creating a federal budget for automatic
transfers from one region to another within Europe
(fiscal federalism).
This last case is politically unacceptable: Germans may
be expected to raise taxes to finance transfers to
France suffering from unemployment, budget deficit and
trade deficit. Can this work politically within the EU?
Currency Area”?
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No significant federal budget for
the EU as a whole: EU budget
amounts to a few percentage points
of the combined EU GDP.
Limited amount of labor mobility
(though getting more flexible)
BUT capital mobility is almost full.
The case for fiscal federalism at
the EU level?
How
likely
is
this?
Political
constraints? Issue of sovereignty?