9. Common Currency Areas

Question 1

What are the benefits of a single currency

Answer 1

Reduced transaction cost

Less price discrimination

ELiminates exchange rate fluctuations - reduced uncertainty for businesses engaging in trade
- Businesses deal with uncertainty with forward foreign contracts - cost money
- Involve buying stuff at fixed exchange rate before
-Absence of exchange rate fluctuations make long term business planning easier

Question 2

What are the costs of a single currency

Answer 2

Gives up:
1. Freedom to set own monetary policy (interest rates, money supply)

2. Possibility of macro adjustment through changes in ER

Question 3

What is the effect of the Euro? how does it compare to the UK/US?

Answer 3

Euro - began 1999, first notes in 2002
- Euro countires adopted fixed ERs - imposed cost and benefits above
- Supported by trade framework (UK recently left it)
- UK never adopted common currency

UK/US:
- Compromise quite different regions - especially US - trade off fundamentally the same as in the EU (regions similar to having countries in the EU)
- Of course the scale of trade off is much reduced

Question 4

How are the costs of a single currency illustrated?

Answer 4

On page 29

Shift in preferences away from Germany goods and towards French goods
- Asymmetric shock - AD curve shifts left in Germany, right in France

Unemployment and pressure on prices in germany; decreased unemployment and upward pressure on prices in France

In the long run the countries return to natural rates of unemployment as wages and prices fall relatively in GErmany and SRAS shifts

Question 5

What would have happened in the example if both countries reatained seperate countries?

Answer 5

• Short run AD fluctuations alleviated by movement in exchange rate

1. Depreciate germany currency, increase in net exports and boost AD (opposite for france)

Germany policy makers would want to cut interest rates to boost AD, whilst French makers would want a rise to contain inflation

(illustrated on page 29)

Clearly the ECB couldnt satisfy both countries - one size fits all monetary policy does not work here, creating policy disagreement

Question 6

What are some examples of recent events which caused asymmetric shocks?

Answer 6

Note mechanism pervasive when exchange rates can adjust, asymmetric shocks similarly:
- Financial crisis imposed major asymmetric shocks
- Pandemic also imposed asymmetric shocks, as well as UKraine conflict

Question 7

What are the characteristics of an OCA?

Answer 7

Benefits > costs

Reducing costs:
- Short run trade off between unemployment and inflation, so more quickly economies reach long run equilibrium, lower the asymmetrical shocks

Real wage flexbility - wages respond quickly

Labour mobility between member countries - alleviates inflationary/employment pressures

Similarity between economies e.g. industry - shocks hit economies less

Capital mobility - countires in recession borrow from those in booms to make up for temporary fall in incomes

Increasing benefits:
- Trade integration among group of countries - greater gain from both reduced transaction costs and exchange rate volatility

Question 8

Is Europe an OCA?

Answer 8

Substantial trade but labou and wage flexiblility low in the EU, means shocks asymmetric

However answer not clear

e.g. 2008 lack of independent monetary/ER policy imposed costs on southern European countries
- South East not competitive but exchange rates cannot depreciate - creates issues as means less competitive perpetually

Question 9

What are the rules for fiscal policy in CCAs?

Answer 9

MUs prevent independent monetary policy - countries may retain control over fiscal policy, used to ameliorate loss of MP

Or may not: Fiscal federalism (fiscal union) involves common fiscal budget and system of fiscal transfers across countries