Chapter 3:The Benefits of a

Common Currency

De Grauwe:Economics of Monetary Union

Introduction

• The costs of EMU have mostly to do with macroeconomic management

• The benefits are mostly microeconomic in nature – i.e. they arise from efficiency gains of a monetary

union

Sources of benefits

• Less transactions costs• Price transparency• Less uncertainty• Benefits of an international currency• Does monetary union lead to more economic

growth?

Less transactions costs

• Elimination of foreign exchange markets within union eliminates cost of exchanging one currency into another

• Cost reductions amount to 0.25 to 0.5% of GDP (according to European Commission)

• Full cost reduction only achieved when payments systems are fully integrated– TARGET payment system– New initiatives to create a Single Euro Payments

Area (SEPA)

Price transparency

• One common unit of account facilitates price comparisons

• Consumers “shop around” more• Competition increases• Prices decline and consumers gain

Will euro increase price transparency in a significant way?

• Large price differentials continue to exist• These have to do with

– transactions costs at the retail level – and product differentiation

• See next tables

Table 3.1: Relative difference in intra- and inter-country price dispersion for selected products (excluding VAT), 2000

Dispersion across Average dispersion Countries inside countries (inter-country) (intra-country)

Supermarket products EVIAN MINERAL WATER 43% 4% REXONA DEODORANT 21% 2% SENSODYNE TOOTHPASTE 21% 2% MARS BARS (SINGLE) 21% 2% MARS BARS (MULTIPACK) 22% 3% COCA COLA 21% 4% PEDIGREE PAL DOG FOOD 10% 2% PLENITUDE FACE CARE 21% 5% COLGATE TOOTHPASTE 14% 4% BONNE MAMAN MARMELADE 19% 6%

Electronic products PHILIPS AUDIO SYSTEM 28% 20% SONY AUDIO SYSTEM 38% 25% CANON CAMCORDER 32% 6% PANASONIC PORTABLE CD 40% 11% PHILIPS PORTABLE CD 56% 20% PIONEER CD PLAYER 34% 12% SONY CD PLAYER 28% 12% PHILLIPS TV (14 inch) 41% 22% SONY TV (14 inch) 33% 19% PANASONIC TV (28 inch) 25% 24% PHILIPS TV (28 inch) 61% 49% JVC VCR 30% 16% PANASONIC VCR 22% 26% SONY VCR 44% 25% Source: European Commission, Price dispersion in the internal market, and Price differentials for supermarket goods in the EU. Both documents can be downloaded from www.europa.eu.int

Table 3.1: Relative difference in intra- and inter-country price dispersion for selected products (excluding VAT), 2000

Dispersion across Average dispersion Countries inside countries (inter-country) (intra-country)

Eurozone has not increased price convergence

Source:Wolszczak-Derlacz (2006)

• Euro has not changed this• There is no evidence of price convergence• Euro may work indirectly by triggering further market integration in particular sectors, e.g. banking, insurance

0,25

0,3

0,35

0,4

0,45

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

mea

n s

tan

dar

d d

evia

tio

n

Figure 3.1: Evolution of price dispersion in the Eurozone, 1990–2005

The introduction of the Euro and perceived price increases

• A major surprise about the introduction of the Euro is its unpopularity in a number of Southern countries

• Especially in Italy, but also in Greece, the introduction of the Euro is associated with massive price increases

Table 1: Price increases of food products (from Nov 2001 to Nov 2002) Breakfast (bread, snacks) 23,3% Pasta, bread, rice 20,1% Beverages 32,9% Meat, eggs and fresh f ish 22,1% Cold cuts 27,5% Canned food 30,9% Fruit and vegetables 50,8% Frozen food 23,6% Total 29,2%

Possible explanation:•Low budget items, with low price elasticities•Competitive markets make it difficult to raise prices•Introduction of Euro creates signal lowering the cost of collective action

Less exchange risk

• Euro eliminates exchange risk. Two issues:– Does the decline in exchange risk increase

welfare?– Does the decline in exchange risk reduce systemic

risk?

Less exchange risk and welfare• Take individual firm under perfect competition

Price certainty Price uncertainty

P P

q q

MC MC

P1 P1

P2

P3

F

G

E

B

C

• Profits are higher on average when there is price uncertainty

• Welfare will then depend on degree of risk aversion

• If risk aversion sufficiently high price certainty is preferred by firms

• Model has a number of important assumptions:– No adjustment costs– With sufficiently large price declines firms can go

bankrupt; model assumes no bankruptcy costs

Exchange rate uncertainty and the price mechanism

• Large exchange variability reduces the quality of price signals in allocating resources

• Example: large overvaluation of dollar in 1980s led to decline of export sector; a decline that turned out to be unnecessary once the dollar declined again

• These large real exchange rate cycles lead to large adjustment costs

Monetary Union and economic growth

• Neo-classical growth modely

k

f(k)

r

r

A

Potential growth effects of monetary union

y

k

f(k)

r

r

A

r’

r’

B

•MU eliminates exchange risk and may reduce systemic risk. If so, real interest rate declines•rr-line becomes flatter (r’r’)•Economy moves from A to B•Per capita income increases because of capital accumulation•Economic growth increases during transition from A to B

Endogenous growth and monetary union

y

k

f(k)

A

B

C f’(k) •Capital accumulation can lead to dynamic effects leading to technological innovations.•Production function f(k) then shifts outwards raising economic growth

Empirical evidence about monetary union and growth

• First generation empirical studies found little relation between exchange rate volatility, trade and investment

• Using cross-section evidence Andy Rose recently found strong effect of monetary union on trade:– A monetary union doubles trade among members

of union, on average– More recent econometric evidence has reduced

these effects to 10%-20%

• The link monetary union-trade then has positive effect on per capita income (Frankel and Rose)

Benefits of an international currency

• International use of the dollar creates seigniorage gains for the US

• Similarly, if Euro becomes an international currency, seigniorage gains will follow for Euroland

• These gains, however, remain relatively small:– in the case of the US: less than 0.5% of GDP per

year

Benefits of monetary union and openness

Benefits(% of GDP)

Trade (% of GDP)

•Benefits of monetary union are likely to be larger for relatively open economies•In absence of monetary union, transactions costs and exchange risk are larger for firms in very open economies•Monetary union will be more beneficial for firms in very open economies•Upward sloping benefit line

Box 5: Fixing exchange rate and systemic risks

IS

ISU

ISL

LMr

rf

yyUyL

F

Shocks in IS-curve:

Monetary union increases variability of output

y’L y’U

IS

ISU

ISL

LMr

rf

yyUyL

G

LMU

LML

y

Shocks in LM-curve

Monetary union reduces variability of output