Economics

2. Macroeconomics
Part VI - Common currency areas and the European
monetary union.
The financial crisis and sovereign debt.

2023/2024, P4
 Common currency areas (currency union, or
monetary union)

• Geographical area through which a common currency circulates.

• Group of countries that adopted permanently fixed exchange rates among
their various currencies. Ex: 1€=200.482 Portuguese escudos
• Ex: European Monetary Union (EMU)

• Single European Market: “ensures free movement of goods, services,

capital and persons in a single EU internal market”.
– Incomplete because some barriers within the single market remain (e.g.,
fragmented national tax systems; separate national markets for financial
services, energy, and transport; among others)
– Source: https://european-union.europa.eu/priorities-and-actions/actions-
topic/single-market_en
• Countries still compete with one another, seeking their national interests
instead of the common good of the EU (recall the prisoneers’ dilemma).

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 Benefits and Costs of a common currency

• Benefits
– Elimination of transaction costs (associated with converting currencies;
banks lose these commissions, but still there is a global net gain)
– Reduction in price discrimination (it becomes harder to sell the same
good at different prices in different countries; more transparency, more
competition)
– Reduction in foreign exchange rate variability (thus reducing the risks
associated with imports and exports)

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 Benefits and Costs of a common currency

• Benefits
– Elimination of transaction costs (associated with converting currencies;
banks lose these commissions, but still there is a global net gain)
– Reduction in price discrimination (it becomes harder to sell the same
good at different prices in different countries; more transparency, more
competition)
– Reduction in foreign exchange rate variability (thus reducing the risks
associated with imports and exports)

• Costs
– Give up own monetary policy and macroeconomic automatic
adjustments through changes in the external value of own currency. A
“one size fits all” monetary policy implies that for countries with
inflation below/above the average, this monetary policy will be too
tough/soft. This is why before entering the euro area countries must
have inflation and interest rates close to the EU average.

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 Optimum Currency Area (OCA)

• In an Optimum Currency Area (OCA) the costs of a single currency

are minimized and the benefits are maximized

• Minimizing the costs (fast convergence to the natural rates of

unemployment and output)
– High wage flexibility
– High labour mobility
– High financial capital mobility (more difficult for physical capital)
– Symmetric macroeconomic shocks, i.e., happening at the same time
and with the same impact in all countries, so that a common
macroeconomic policy response is adequate (for instance, countries
with synchronized business cycles, entering recessions and recovery
phases at the same time)

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 Optimum Currency Area (OCA)

• Maximizing the benefits

– High degree of trade integration between the member countries, i.e.,
large amount of international trade (increases the benefits of
transaction costs reduction and of decreased exchange rate
volatility)
• Trade integration is measured as (X+M)/GDP
• Some argue that trade integration is endogenous, that is, it
increases because of the benefits of the currency union (trade
integration improves the benefits of a single currency, and a
single currency promotes more trade integration)

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 Common currency area trilemma

Robert Mundell (1932-2021): influential research on optimal

currency areas. That’s why he is sometimes considered “the
father of the euro”.

His seminal research stresses the advantages of a single

currency in order to decrease transaction costs and
uncertainty, as well as the adjustment costs created by the
difficulty of maintaining full employment when regions are
subject to different shocks.

He presented an “impossible trinity” - we can only have two

of the following three: fixed exchange rates, independent
monetary policy, free capital movement. In the euro area we
have fixed exchange rates and free capital movement, but
not independent monetary policy.

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Robert A. Mundell (born 1932, Canada—died
2021, Italy) Economist who in 1999 received
the Nobel Prize for Economics for his work on
monetary dynamics and optimum currency
areas.
Mundell’s question: when is it advantageous for
a number of regions to give up their monetary
sovereignty in favor of a common currency?
He put forward the theory that a
single currency would be viable in an economic
region, or optimum currency area, in which
there was free movement of labour and trade.

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 CCA and OCA

https://www.nobelprize.org/prizes/economic-sciences/1999/press-release/

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 OCA

Since Mundell’s work, economists have agreed on four criteria that must be met for
an OCA:
- regions should be exposed to similar sources of economic disturbance (common
shocks)
- the relative importance of these shocks across regions should be similar
(symmetric shocks)
- regions should have similar responses to common shocks (symmetric responses)
- if regions are subject to region-specific economic disturbances (idiosyncratic
shocks), they need to be capable of quick adjustment.
Regions satisfying these criteria will have similar business cycles, so a common
monetary policy response would be optimal.

https://www.chicagofed.org/publications/chicago-fed-letter/1999/october-146

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 https://www.ecb.europa.eu/euro/intro/html/index.en.html

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 Is the EMU an OCA?

• Gains from trade integration may have reached 0.5% of GDP,

which is significant
• Restrictive labor laws, slow AS adjustment
• Low labour mobility (culture, language barriers, …)
• High wholesale financial markets integration (banks borrow from
any other bank, at a common rate for all), but low retail financial
markets integration (persistent cross-country differences in bank
lending rates and few cross-border retail banking activity)
• Timing of ups and downs seems to be close across EMU countries,
but some experience much stronger growth and/or much stronger
downturns (ex: Ireland, Greece)

• Is EMU and OCA?

• Test: see whether EMU survives in the long run. There were doubts during
the financial crisis, but not during the pandemic or because of the war.
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 Fiscal policy in a Common Currency Area

• Fiscal policy can be used to ameliorate the loss of monetary

policy autonomy.

• However, if the debt of one country increases, there are

consequences for the other members:
– If interest rates on government debt are high, it becomes almost
impossible to repay, especially if economic growth is weak.
– Excessive debt issuance by one member will push up the cost
of borrowing for the other members.

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 Fiscal policy in a Common Currency Area

• But creditors believe that the other members will support the
country to avoid its default, and the interest rate does not rise
so much. Being a Common Currency Area (CCA) member is a
sort of insurance because the others won’t let you fall (it’s not
in their interest, otherwise the price of their debt will also rise
and there will be strong selling of euros in the exchange
market). This is a free-rider problem.

• Other members try a ‘no bailout’ clause, but it is not credible.

• Hence, fiscal rules exist for all member States (Stability and
Growth Pact – “set of rules designed to ensure that countries in
the European Union pursue sound public finances and
coordinate their fiscal policies”).
• Sovereign debt = bonds issued by national governments to
finance expenditure
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 Structural and cyclical deficits

• Cyclical deficit: associated with the business cycle. In times of

economic growth revenue from taxes increases and welfare
spending falls, so the deficit shrinks; in times of economic
slowdown the opposite occurs, and the deficit enlarges.

• Structural deficit: not dependent on movements of the economic

cycle; indicates that the Government is “living beyond its means”.

• Should structural deficits be a cause for concern? Should the

Government balance its budget, or not? Austerity or growth?

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 10-year
Government
bond yields

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http://www.worldgovernmentbonds.com/spread-historical-data/
 10 April 2024
Source: https://www.investing.com/rates-bonds/de-10y-vs-pt-10y

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 Austerity or growth?
Financial crisis and sovereign debt

• Arguments for austerity are based on the long-term

benefits, although there exist considerable short- and
medium-term effects. Moreover, it is unfair to make
tax-payers of countries that have abided by the rules
to pay for the other countries.

• The argument for growth is based on the idea that to

solve the debt crisis we need economies to grow (so
the ratio Debt/GDP falls).

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 Readings

Mankiw and Taylor, Ch. 37, Ch. 38.

And also…

https://latinamericareports.com/could-the-sur-become-the-euro-of-latin-america/7416/
https://www.ft.com/content/5347d263-7f24-4966-8da4-79485d1287b4
https://www.theatlantic.com/international/archive/2023/03/latin-america-currency-union-argentina-brazil-
el-sur/673449/