What are the microeconomic benefits of a currency union?

Q1. Considering the current budget deficit/debt problems faced by some members of the Eurozone, critically evaluate the argument that countries in a monetary union should coordinate their fiscal policies (1500 Words)

Core Information: Carl & Soskice (2015) Textbook – Macroeconomics: Institutions, Instability, and the Financial System, Relevant Chapter: 12- The Eurozone

The textbook is available online through sources such as Academia, just make an account and the whole textbook and referenced chapters are on there.

Below are some discussions from the seminar we did relating to the topic, should give an overview of the taught material and provide the basis for certain arguments, as well as providing the foundation for more academic related arguments through the use of journal articles and reports. (Discussion below is more or less based off chapter 12 in the above textbook)

1. What are the microeconomic benefits of a currency union?

There are 4 main microeconomic benefits:

1. The elimination of exchange rate risk should lead to higher levels of trade and investment.
2. Real resources are saved with the removal of transactions costs that occur during currency conversion.
3. Increased competition in the product and labour markets, due to greater ease of price and wage comparisons.
4. Increased liquidity in financial markets. This is of particular benefit for small member countries.

2. Germany had a credible central bank before the introduction of the euro. What was their macroeconomic incentive to join the currency union? Was this incentive shared by the countries in Southern Europe?

The main macroeconomic incentive for Germany to join the Eurozone was that other countries in the CCA could no longer competitively devalue. Countries in Southern Europe had often followed this policy before the 1990s, harming German’s exports. These countries gave up this possibility in order to attach themselves to a credible low inflation monetary policy regime, designed along the lines of the Bundesbank.

3. What are the two pillars of the ECB’s monetary policy? Discuss the pros and cons of the ECB’s strategy.

The two pillars of the ECB’s monetary policy are economic and monetary. The economic pillar makes use of the analysis of forecasts of the output gap and the deviation of inflation from target to inform the interest rate decision. In contrast to most other independent central banks (e.g. the Bank of England), the ECB has an asymmetric inflation target. The target implies that the ECB would be happier with inflation 1% below target than 1% above target. The target has been criticized on the grounds that it leaves the Eurozone more vulnerable to deflation than would be the case with a symmetric target. The second, or monetary, pillar uses a reference growth rate of a broad monetary aggregate. Economists have criticized this second pillar, on the basis that other central banks in the past failed to successfully target money growth. In contrast, monetary economist (and former member of the Bank of England’s Monetary Policy Committee) Charles Goodhart (2006) argued that if inflation expectations come to be more closely anchored to the target, inflation may no longer be a good signal of future inflationary pressure. Under these circumstances, relying only on the economic pillar could be misleading and the growth rate of a money aggregate may be a more relevant indicator of future inflation.

4. What is the Walters’ critique and why was it used as an argument for the UK not joining the single currency?

According to British Economist Alan Walters, if a principle similar to the Taylor rule is not applied to a member of a CCA, so that the required negative output gap is created to dampen inflation (through the combination of tighter fiscal policy and the operation of the real exchange rate channel), then instability can arise. Walters used this argument to reinforce his reasoning against UK membership of the euro.

5. Use the 3-equation model to show how fiscal policy can be used to stabilise the economy after a positive demand shock in a country that is a member of a common currency area (CCA). What effect does this have on the budget balance?

The demand shock increases output above equilibrium and increases inflation. As the country cannot adjust its nominal interest rate (as it is set by the CCA monetary authority), this higher inflation will reduce the real interest rate. The government will respond with a contraction of government spending, to create the desired negative output gap as prescribed by the PR curve. The real exchange rate will also become more appreciated

due to this period where home’s inflation is above world (or CCA) inflation. The government will continue to adjust government spending to guide the economy along the PR curve and back to equilibrium. Once back at equilibrium, the economy will have an appreciated real exchange rate and a primary government surplus. This is because the demand shock cannot be totally countered by the appreciation of the real exchange rate as it is in a small open economy with flexible exchange rates. The real exchange rate also experiences some nominal appreciation in the flexible exchange rate regime, but this is not possible in a fixed exchange rate regime (or a CCA).