Inflationary Pressure and Labor Conflict

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Different Fiscal Systems and the Seigniorage ProblemCountries have different fiscal systems

This leads countries to use different debt and monetary financing of the government budget deficit

In a monetary union countries will be constrained in the way they finance their budget deficitsTheory of Optimal Public FinanceRational governments will use different sources of revenue so that the marginal cost of raising revenue through different means is equalizedIf the marginal cost of raising revenue by increasing taxes exceeds the marginal cost of raising revenues with inflation (seigniorage) it will be optimal to reduce taxes and to increase inflationCountries will have different optimal inflation ratesGenerally countries with an underdeveloped tax system will find it more advantageous to raise revenues by inflation (seigniorage)Different Fiscal Systems and the Seigniorage Problem Main PointLess Developed Countries that join a monetary union with more developed countries that have a low rate of inflation will also have to lower inflationThis means they will have to increase taxesLeads to a loss of welfare

Seigniorage Revenues (as % of GDP)1976-851986-901993Germany0,20,60,5Greece3,41,50,7Italy2,60,70,5Portugal3,41,90,6Spain2,90,80,6What About Symmetric Shocks?

Can France and Germany deal with this negative shock in a monetary union?Symmetric ShocksFrance and Germany can deal with a negative shock in a monetary union because monetary policy is centralized in the hands of the European Central BankOne interest rate for both countries due to ECBIf ECB lowers the interest rate it stimulates aggregate demandECB would be paralyzed in case of an asymmetric shockEx: if ECB reduces interest rates to stimulate demand in France it increases inflation in GermanyIf ECB increases interest rates to deal with German inflation it reduces demand in FranceIf France and Germany are NOT in a monetary unionIs devaluation an attractive policy option for one of the countries facing a symmetric shock?NO!!Ex: France devalues aggregate demand stimuated at the expense of GermanyThis shifts the German aggregate demand curve further to the leftFrench export their problem to GermanyThen Germany would react with its own devaluation danger of a spiral of devaluationsThe two countries would have to coordinate their actions difficult for 2 independent statesThere is an advantage of a monetary union when faced with symmetric shocks (but not asymmetric shocks)Critique of Optimum Currency AreasSo far we have looked at why countries may find it costly to join a monetary union

This analysis is known as The Theory of Optimum Currency Areas (OCA)

Criticism of OCA:The differences between countries may not be all that importantThe exchange rate mechanism may not be very effective in correcting for differences between nationsThe exchange rate may do more harm than good in the hands of politiciansI.1. The differences between countriesThere is no doubt that there are differences among countriesQuestion: Are these differences important enough to represent a stumbling block for monetary unification?Classical Mundell analysis:Demand shift from one country to anotherIs this likely to occur frequently between the European countries that form a monetary union? Two views exist:European Commission viewPaul Krugman viewE.C. ViewDiferential shocks in demand will occur less in a monetary union

Reason: Trade between the industiral European nations is largely intra-industry trade based on economies of scale and imperfect competition

Countries buy and sell to each other in the same category of products (ex. France sells cars to and buys cars from Germany)E.C. View (cont.)This structure of trade leads to most demand shocks having similar effects in both countriesEx: fewer demand for cars means fewer French and German cars get sold demand is affected similarly in both countries

Removal of barriers in a single market will reinforce these tendencies

Demand shocks will become symmetric as opposed to asymmetricPaul Krugmans ViewTrade integration leads to regional concentration of industrial activitiesThis leads to localization of industriesConcentration of production to profit from economies of scaleTrade integration leads to more concentration of regional activitiesRegional Distribution of Auto Production, 1991USAEUMidwest66,3Germany38,5South25,4France31,1West5,1Italy17,6North-East3,32UK12,9Paul Krugmans View (cont.)When the EU becomes more integrated, it may become like the USA

This suggests that sector-specific shocks may become country-specific shocks

Countries faced with these shocks may then prefer to use the exchange rate as an economic policy to correct for disturbancesEC View and Krugman View Compared

Divergence: Degree of divergent movments of output and employment between groups of countries (regions) which are candidates for a monetary unionTrade Integration: Degree of trade integration between these countriesE. C. View

As the degree of economic integration between countries increases, asymmetric shocks will occur less frequently (so that income and employment will tend to diverge less between the countries involved)Paul Krugmans View

When economic integration increases the countries involved become more specialized so that they will be subjected to more rather than fewer asymmetric shocksEC vs. Krugman ViewThere is a presumption in favor of the EC view because:Even though economic integration can lead to concentration and its effects cannot be disputed however, as market integration between countries proceed national borders become less and less importantMost likely clusters of economic activity will encompass bordersEx: auto manufacturing in the region encompassing South Germany and North Italy in this case shocks in the auto industry will affect more than one countryThe argument is not that concentration will not happen but that national borders will become less relevantRegions may as a result experience asymmetric shocks regions may overlap existing bordersEconomic forces of integration are likely to decapacitate the exchange rate between national currencies as a force to deal with these shocksEC vs. Krugman ViewEmpirical analysis suggests that economic integration will make asymmetric shocks between nations less likelyThe rise of services: economies of scale do not matter as much for services as for industrial activitiesEconomic integration does not lead to regional concentration of services in the way it does with industriesThere is no regional integraiton in services and this sector counts for 70% or more of GDP in many EU countries2. Effectiveness of the Exchange Rate MechanismNot all asymmetric shocks will dissapear This is because nation-states still remain the main instruments of economic policiesIn the European Economic and Monetary Union monetary policies are centralized (due to the ECB) and therefore cease to be a source of asymmetric shocksMember countries however still ahve sovereignty in other economic areas:Budgetary FieldNational Economic InstitutionsBudgetary FieldMost spending and taxing powers still vested in the hands of national authoritiesBy changing taxes and spending a nation can create asymmetric shocksThese shocks will be contained within the borders of that nation-stateEx. When a country raises taxes o wage income it only affects labor, spending and wage levels in that particular countryThese may lead to asymmetric shocks with other countriesNational Economic InstitutionsEx: Wage bargaining systems

Ex: Legal Systems

Ex: Financial SystemsAlthough economic integration is likely to weaken the occurrence of asymmetric shocks the existence of nation-states with their own peculiarities will be a continued source of asymmetric disturbances in a monetary unionThis has led some economists to argue that in order for a monetary union to function satisfactorily more political unification is necessaryMonetary union should also put pressure on further political integration within member states3. Institutional Differences in Labor MarketsWill monetary integration change the behavior of labor unions? (so that differences may dissapear)National governments can still create employment in the government sector but now finance it by issuing debtThus the effects of labor unions should not be completely disregardedInstitutional differences in the national labor markets will continue to exist leading possibly to divergent wage and employment tendencies and severe adjustment problems when the exchange rate instrument is not available4. Different Legal and Financial SystemsFinancial markets work differently across the EUTheres a risk that some monetary shocks will be transmitted differentlyEx. Investors in high inflation coutnries like Italy do not tend to buy long term bonds in fact the long term bond market hardly exists government debt is mostly short-term; it is exactly the opposite case in a low-inflation country like Germany4. Different Legal and Financial Systems (cont.)Maturity distribution of government bonds (% of total)Short-term (- 1 year)Medium and long term (+1 year)Of which long term (+5 years)Italy49,450,624,8Germany18,581,5-Netherlands6,793,363,0All this caused asymmetries in the way EU-governments reacted to the same interest rate changes in the pastEx. When the interest rate changed, the Italian government budget was immediately affectedItalian debt has short maturity, interest rates go up, Italian government spends more on interest payments, budget deficit increasesThese differences due to inflation will dissapear in a monetary union4. Different Legal and Financial Systems (cont.)Monetary union by itself will eliminate some of the institutional differences that exist between national financial systems however deeper differences like those that are the result of different legal systems will only dissapear by a convergence of national legal systemsThis means further political integration5. Differences in Growth RatesFast growing countries = fast growing importsDepreciation of currency needed to allow exports to growMonetary union makes this impossibleThis popular view has very little empirical support1. Paul Krugmans reason against this view: Economic growth is rarely like the scenario mentioned above it usually has to do with the development of new products there is higher income elasticity on their exports these countries can grow faster without incurring trade balance problemsNo depreciations needed5. Differences in Growth Rates (cont.)2. Existence of Capital Flows: slow-growing countries will invest in the faster-growth countryFast-growing country can finance current account deficit without devaluing its currencyIn fact by joining a monetary union, a fast growing country may attract more foreign capital (since there is also no exchange rate uncertainty)

Differences in the growth rates of countries cannot really be considered as an obstacle to monetary integrationII. Nominal and Real Depreciations of CurrencyBy giving up ones national currency a country cannot change its exchange rate any more to correct for shocks in demand, costs or pricesQuestion: Are these exchange rates effective in making such corrections?Do nominal exchange rate changes permanently alter the real exchange rate of a country?If the answer is no different countries would not have extra costs when joining a monetary union1. Devaluations to correct for asymmetric shocksIn the previous story of France and Germany France devalues to cope with the problem

1. Devaluations to correct for asymmetric shocks (cont.)Nominal exchange rate cahnges have only temporary effects on the competitiveness of coutnries. Over time the nominal devaluation leads to domestic cost and price increases which tend to restore the initial competitivenessNominal devaluations only lead to temporary real devaluationsDo countries not lose anything by relinquishing this instrument?NO!! They do lose something short-term effects in the absence of a devaluation1. Devaluations to correct for asymmetric shocks (cont.)In the long run the two policies (devaluation and expenditure reduction) lead to the same effect on output and the trade accountIn the long run the exchange rate will not solve problems that arise from differences between countries that originate in the goods markets. Manipulating money cannot change the real differencesTheir differences are in the short-term effectsWhen a country devalues it avoids severe deflationary effects on domestic output during transition inflation increasesIn expenditure-reduction inflation is avoided however output decreases during the transition period1. Devaluations to correct for asymmetric shocks (cont.)Although a devaluation does not have a permanent effect on competitiveness and output its dynamics will be quite different from the dynamics engendered by the alternative policy which will necessarily have to be followed if the country has relinquished control over its national moneyThis loss of a policy instrument will be a cost of the monetary union2. Devaluations to correct for different policy preferencesThe model of Italy and Germany and the Phillips Curve and the preferences of each one of these countries was a concernBoth countries would have to accept unpopular points in the curve when joining a monetary union

2. Devaluations to correct for different policy preferencesThis analysis depends on the assumption that the Phillips curve is stable which it is not

Countries differ in terms of their preferences towards inflation and unemployment these differences are not a serious obstacle to joining a monetary union since countries cannot choose an optimal point on the Phillips curve

3. Productivity and inflation in a monetary unionUpto now we have assumed that national inflation rates will be equalized in a monetary unionTHIS IS NOT TRUE!!There are regional differences even though they tend to be small they can be significantEx. When Germany and Ireland are in a monetary union competition makes sure that the price changes of tradeable goods are equalizedBut this does not happen in non-tradeable goods (like electricity and water) because there is no international competitionCONCLUSIONThe traditional theory of OCAs tends to be rather pessimistic about the possibility for countries to join a monetary union at low costThe criticisms we have discussed are much less pessimisticThe main reasons:The ability of exchange rate changes to absorb asymmetric shocks is weaker than the traditional OCA theory has led us to believeExchange rate changes usually have no permanent effects on output and employmentCONCLUSION (cont.)Countries that maintain independent monetary and exchange rate policies often find out that exchange rate movements can lead to macroeconomic disturbances instead of macroeconomic stabilization

Exchange rates, contrary to popular belief, cannot be used frequently and costlessly

CONCLUSION (cont.)OCA theory though still has relevance because:

There are differences between countries that have political and institutional origins (ex. Labor markets, legal systems, governments, ...) which will continue to exist

These can lead to adjustment problems in the future

CONCLUSION (cont.)The risks of high adjustment costs in the face of asymmetric disturbances can be reduced by:

Making markets more flexible (so that asymmetric shocks can be adjusted better)Speeding up the process of political unification (this will reduce the occurance of asymmetric disturbances that have a political or institutional origin)Benefits of a Common CurrencyCosts have to do with macroeconomic management of the economy

Benefits have to do with the microeconomic aspect

Eliminating national currencies for a common currency leads to economic efficiency gainsElimination of transaction costsElimination of exchange rate risk

Benefits of a Common Currency (cont.)Direct gains from the elimination of transaction costsEliminating the costs of exchanging one currency into another is themost visible gain from a monetary unionE.C. Estimates these gains between 13-20 billion/yearOf course banks will lose revenue they get for exchanging national currencies in a monetary unionBenefits of a Common Currency (cont.)Indirect gains from the elimination of transaction costsThe scope for price discrimination between national markets will be reducedThe unification of currency along with the other measures in creating a single market will make price discrimination more difficultThis is a benefit to the European consumer

Benefits of a Common Currency (cont.)Welfare gains from less uncertainty

The uncertainty about future exchange rate cahnges introduces uncertainty about future firm revenues

Welfare of firms will increase when common currency is introduced (exception: firms that make money by taking on risk)