week 10

Question 1

Benefits of a single currency [3]

Answer 1

1. Reduced transaction costs: Adopting a single currency lowers costs associated with currency conversion, eliminating deadweight loss.
2. Reduced price discrimination: A single currency makes it harder to hide price differences between countries, reducing deadweight loss associated with price discrimination.
3. Elimination of exchange rate fluctuations: This

a) reduces uncertainty for businesses,

b) promotes trade and investment by making long-term planning easier and less costly.

Question 2

Note that businesses can always deal with such uncertainty by engaging in …?

Answer 2

forward foreign exchange contracts.

But such contracts cost money (another deadweight loss)

Question 3

Costs of a single currency? [3]

Answer 3

1. Joining a currency union gives up

a*) freedom to set its own monetary policy (ir)

b) the possibility of macroeconomic adjustment thru changes in ER

e.g Euro countries adopted fixed exchange rates which imposed costs and benefits of the types just mentioned

2. Asymmetric Shock
3. Currency union implies a “one size fits all” monetary policy

Question 4

Explain the cost “asymmetric shock”

Answer 4

Suppose there is a shift in consumer preferences away from German goods and in favour of French goods.

• AD curves will shift asymmetrically: To the left in Germany and to the right in France.

Thus, Inc. unemployment + downward pressure on prices in Germany; decreased unemployment and upward pressure on prices in France

If the governments do nothing then the economies will, in the long run, return to their natural rates of unemployment as wages and prices fall (relatively) in Germany and SRAS shifts

Question 5

Draw the asymmetric shock diagram

Answer 5

Question 6

But:

• If the two countries had retained separate currencies then…?

Answer 6

The short-run fluctuations in aggregate demand would have been alleviated by a movement in the exchange rate

Depreciation of German currency would increase German net-exports and boost AD (conversely for France)

Question 7

Draw the asymmetric shock diagram if currencies were seperate

Answer 7

Question 8

Explain what is meant by the “one-size fits all” policy

Answer 8

German policy makers want cut in interest rates to boost aggregate demand, while French policy makers will want a rise in the interest rates to contain inflation

• The ECB would be unable to satisfy both countries

Question 9

Examples of asymmetric shocks?

Answer 9

Pervasive when exchange rates cannot adjust:

• Great Financial Crisis imposed major asymmetric shocks across Europe
• Pandemic imposed asymmetric shocks across Europe
• Ukraine conflict has imposed major asymmetric shocks across Europe

Question 10

What is Optimum Currency Area Theory?

Answer 10

An optimum currency area is a group of countries for which it is optimal to adopt a common currency and form a currency union

• This just means that the benefits outweigh the costs

Question 11

Characteristics of countries that reduce costs (for having a singular currency) [4]

Answer 11

1. High degree of Real wage and price flexibility:
   Quick wage response to unemployment fluctuations reduces asymmetry costs by swiftly restoring long-run equilibrium after economic shocks, minimising the short-term trade-off between unemployment and inflation.
2. High degree of Labour mobility: The faster economies move to long-run equilibrium after shocks, the lower the ‘asymmetry costs’ + ensured macroeconomic stability. For instance, migration of labour from G to F would alleviate inflationary pressure in France and keep down unemployment in
3. Economic similarity and high capital mobility: Economic alignment and the ability to borrow money across countries without domestic interest rate hikes reduce the impact of asymmetric shocks.
   e.g Residents of a country experiencing recession may borrow money from residents of a country experiencing a boom to make up for their temporary fall in income - without domestic interest rates rising
4. ** High degree of trade integration** amplifies benefits, such as reduced transaction costs and exchange rate volatility, leading to greater gains.

Question 12

Is Europe an Optimum Currency Area?

Answer 12

YES: Substantial within-Europe trade (trade-integration)

NO: But labour and wage flexibility are low in the EU

+ Differences in the EU mean that shocks are often asymmetric

The answer is therefore not clear