Lec 3 Flashcards
Explain the Optimal Currency Area
Mundell (1961) defined it with 4 requiremnts:
1) Wage and price flexibility (to allor real exchange rate movements, in the absence of nominal)
2) Labor mobility
3) Fiscal transfers and coordination. So you do not free-ride on other countries’ discipline (fiscal expansions shifts out IS curve without causing appreciation), also causing more debt
4) Integrated capital markets (to allow risk sharing and efficient funding of investments)
What is the policy trilemma?
That you can only have 2 out of 3 of:
Free capital flows
Fixed Exchange rate (currency union is extreme case)
Independent monetary policy
What are the potential benefits of a currency area?
Reduced transaction costs
Elimination of currency and credibility risk
Greater product market integration
Enhanced capital market integration, and, thus risk sharing and investment boosed
What is the “Theory of the 2nd best”
The theory of the second best concerns the situation when one or more optimality conditions cannot be satisfied. If one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would otherwise be optimal. (e.g. 2 roads).
E.g. free capital markets may be a part of the first-best solution, but in the absence of other parts of the first-best (maybe Greece is faking the numbers), may mean that free capital markets are not that good
What were the convergence criteria?
A set of criteria set that countries before joining the Euro needed to bring their economy and legislation up to a set of standards. Were set under Maastricht Treaty (1991). Were not really met in reality.
What were Gordon Brown’s 5 tests?
The five economic tests were the criteria defined by the UK treasury under Gordon Brown that were to be used to assess the UK’s readiness to join the Economic and Monetary Union of the European Union (EMU), and so adopt the euro as its official currency. In principle, these tests were distinct from any political decision to join.
1) compatibility of business cycles and economic structures
2) If problems emerge, is there flexibility to deal with them
3) Would joining create better conditions for investing in UK?
4) Would it improve UK’s competitiveness?
5) Would it promote higher growth, stability and a lasting increase in jobs
What did Nechio (2011)’s research show
Apply a Taylor rule to each Euro-area country based on inflation and unemployment gap.
1) It fits the ECBs policy overall
2) Interest rate should be higher in the Periphery than in the core Euro-zone. The periphery was overly stimulated before the crisis and too tight after the crisis. Necio (2012) shows that discrepancies within the United States where much higher
Discuss the effect of Currency Areas on Capital and Credit Markets?
Main aim is to enhance risk sharing and access to funding for households and firms (when appropriate).
Enhancing and coordinating regulation and crisis response
In the EU, reducing reliance on bank credit (vs markets)
Hard to replicate domestic features such as lender of last resort and deposit insurance at supra-national level
Unintended consequences and (systemic) risks may emerge
What is the evidence on convergence of credit spreads in the Euro area?
Franks (2018)
1980-1998:
Convergence. Countries with high spreads have decreased spreads the most (as compared to Germany.
2007-12:
Divergence. Countries with high spreads have higher spreads (e.g. Greece).
Does however not necessarily say that capital market are not integrated. It shows that parts of real economy are not integrated.
What is the relationship between credit growth and current accounts?
Franks (2018)
In Euro countries in 1999-2007, there is a strong negative relationship between average annual credit-to-GDP growth and average change in current account balance.
Free-flowing funding may have lead to postponed structural reforms in peripheral countries
Theory of the second best. Free capital flows may be bad, if other parts are not in place
What has happened to home bias?
From 1997 to 2012, UK and US have had a small increase in home bias in bonds. Intra area cross-border allocations in euro area in bonds increased until 2006 but has decreased since
What is the ‘diabolical loop’?
The “diabolic loop” or nexus between sover- eign and bank credit risk was the hallmark of the 2009–2012 sovereign debt crisis in the periphery of the euro area. In Greece, Ireland, Italy, Portugal, and Spain, the deterioration of sovereign creditworthiness reduced the market value of banks’ holdings of domestic sovereign debt. This reduced the perceived solvency of domestic banks and curtailed their lending activity. The resulting bank distress increased the chances that banks would have to be bailed out by their (domestic) government, which increased sovereign distress even further, engendering a “bailout loop.” Moreover, the recessionary impact of the credit crunch led to a reduction in tax revenue, which also contributed to weakening government solvency in these countries, triggering a “real-economy loop.”
http://personal.lse.ac.uk/reisr/papers/16-DLESBies.pdf
What is some key evidence on EU capital market breadth and depth
Kudrna (2016):
For most types of capital markets, size as a proportion of GDP is considerably smaller than in the US.
Insurance is larger in the EU.
But market values, equity and debt issuance, M&A, pensions, trading and asset management is smaller.
What does Kudrna find on risk-sharing?
- Eurozone risk-sharing is smaller than US and Canada.
- Eurozone has larger reliance on credit markets and almost no fiscal insurance
Why may spreads and apparent arbitrages not prove something about lack of financial integration?
It may be that part of the real economy are not integrated, such that with well-functioning capital markets, spreads tend to open up
