economics of european integration - stephen...

Economics of European IntegrationLecture 4

Stephen Kinsella

University of [email protected]

September 29, 2009

Stephen Kinsella (University of Limerick) Economics of European Integration September 29, 2009 1 / 21

Today

1 Economic and Monetary Union

2 Optimum Currency Area Theory

3 Costs and Benefits of EMU

4 Ancient Rome: This too shall pass


Learning Outcomes

1 Analyse effects of preferential liberalisation using MS/MD apparatus.

2 Describe optimal currency area theory and criteria

3 Understand EMU, and its costs and benefits.


Learning Outcomes

1 Analyse effects of preferential liberalisation using MS/MD apparatus.

2 Describe optimal currency area theory and criteria

3 Understand EMU, and its costs and benefits.


Part One of Four. Preferential Liberalisation


Preferential Liberalisation: MS-MD Equilibrium

Domestic price

Home

imports

MD

PFT

RoW

Exports

Partner

Exports

XSP XSR MS

M=XP+XR

Partner Home RoW

Border price

2 1

XP X

R


Preferential Liberalisation

Consider Home removes T on imports only from Partner

1st step is to construct the new MS curve The liberalisation shifts up

MS (as with MFN liberalisation) but not as far since only on half of

imports

Shifts up MS to half way between MS (free trade) and MS (MFN T ),

but more complex, kinked MS curve with PTA.


Preferential Liberalisation

Consider Home removes T on imports only from Partner

1st step is to construct the new MS curve The liberalisation shifts up

MS (as with MFN liberalisation) but not as far since only on half of

imports

Shifts up MS to half way between MS (free trade) and MS (MFN T ),

but more complex, kinked MS curve with PTA.


Comparative Statics

Domestic price

Home

imports

MD

PFT

RoW

Exports

Partner

Exports

XSP XSR MS

MSMFN

P’

M’ M=XP+XR

Partner Home RoW

Border price Border price

T

P’-T

2 1

X’R X’

P

XP X

R


What happens to domestic prices?

domestic price falls to P � from P ��

Partner-based firms see border price rise, P � − T to P ��

RoW firms see border price fall from P � − T to P �� − T .


What happens to domestic prices?

domestic price falls to P � from P ��

Partner-based firms see border price rise, P � − T to P ��

RoW firms see border price fall from P � − T to P �� − T .


Home/Border Effects

Domestic price

MD

XSP XSR

MS

MSMFN

M’

Border price Border price

MSPTA

P’

T

P”

P’-T

P”-T

XR” XR’ XP’ XP” M”

P’-T

P”


Welfare Effects of Customs Union Formation1 In market for good 1, Home change = A + B − C1− C22 In market for good 2, Home change = +D1 + D2, and (D1 = C1)3 Net Home impact = A + B − C24 Partner impact identical. RoW loses big time.

euros

imports

MD

euros

Exports

XS

M’

A

D 2

D 1 C 1

B

C2

XP” XP’ XR” XP’

P’-T

P”

P’

P”-T


euros

imports

MD

euros

Exports

XS

M’

A

D 2

D 1 C 1

B

C2


P’-T

P”

P’

P”-T


euros

imports

MD

euros

Exports

XS

M’

A

D 2

D 1 C 1

B

C2


P’-T

P”

P’

P”-T

CU vs FTA

FTA like CU but no Common External Tariff

Opens door to ‘tariff cheats’, goods from RoW destined for Homemarket enter via Partner if Partner has lower external tariff, called‘trade deflection’

Solution is ‘rules of origin’ meant to establish where a good was made.

Problems: Difficult and expensive to administer, especially as worldget more integrated

Rules often become vehicle for disguised protection.

Despite the origin-problem in FTAs, almost all preferential tradearrangements in world are FTAs.


CU vs FTA








CU vs FTA








CU vs FTA








CU vs FTA








Part Two of Four. Optimal Currency Areas


OCA Theory

Mundell (1961), Kenen (1969), Tavlas.

See Francesco Mongelli ECB Article.

Basic Idea: when it is a good idea for 2 or more countries to share acurrency?

Definition (Optimum Currency Area)

[T]he optimal geographic domain of a single currency, or of severalcurrencies, whose exchange rates are irrevocably pegged and might beunified. The single currency, or the pegged currencies, can fluctuate onlyin unison against the rest of the world.


A region is optimal as an OCA to the extent it exhibits:

Labour & factor mobility

Financial market integration. Ingram (1962) noted that financialintegration can reduce the need for exchange rate adjustments.

Production diversification

Openness

Fiscal transfers & fiscal integration

Homogeneous preferences

Commonality of destiny & political integration

OCA theory suffers from problems of inconclusiveness and inconsistency.How can one rank different OCAs? The EMU question is, possibly, morecomplex than the OCA question. Tools just not sophisticated enough.






Openness










Openness










Openness










Openness










Openness






Specialisation versus “Endogeneity of OCA”

!"#$%$&'()*+,$-./0($1'$234$%$5/(*6$7887 !"

Due to the need for relatively long time series for the econometric tests, studiesinvestigating OCA properties are by necessity backward looking. Such studies cannot reflecta change in policy preferences, or a switch in policy regime. In fact, monetary integrationwould represent a structural break for any group of countries adopting a new single currency.A question naturally arises: what type of forces might monetary integration unleash? Lookingahead, we may be confronted with two distinct paradigms -- specialisation versus endogeneityof OCA -- which have different implications on the benefits and costs from a single currency.

6. A Tale of Two Paradigms: Specialisation versus “Endogeneity of OCA”

Frankel (1999) singles out two OCA properties as crucial in assessing the net benefitsfrom currency union: their degree of openness, i.e., the extent of reciprocal trade among agroup of partner countries, and their correlation of incomes (capturing over time diverse otherproperties). Countries sharing a high level of eitheropenness or income correlation , butpreferably both properties, will find it beneficial to share a single currency as illustrated inFigure 2. Their trade-off is illustrated by the downward sloping “OCA line” that shows thecombination of openness and correlation of incomes beyond which the advantages from acommon currency would dominate for a group of partner countries. To the left of the OCAline instead the advantages from monetary independence dominate. The US States and thecurrent members of the euro area (according to us) are located on the right of the OCA line:i.e., they draw net benefits from respectively the US dollar and the euro. Among a groupformed by the US, Japan and Europe the advantages from monetary independence wouldinstead dominate: these countries as a group lie instead on the left of the OCA line.

Frankel also notes that the optimum currency area properties evolve over time. Mostauthors agree that reciprocal trade and openness increase among countries sharing a singlecurrency and a common monetary policy in response to a decline in transportation costs and amore stable exchange rate regime. A case in point are the members of the European Unionthat have removed all trade and financial barriers among each other and share a single market.Reciprocal trade has constantly risen among these countries. Statistical estimates usinggravity model of bilateral trade suggest that membership in the EU increases trade with itsmembers by over 60 percent (Frankel and Wei (1998)). There is disagreement thoughconcerning the extent by which income correlation rises or falls following monetary

Advantages ofcommon currencydominate

Advantages ofmonetaryindependencedominate

OCA Line

Extent of trade among membersof group (Openness)

Correlation ofincomesamong group

Figure 2. Two Key Optimum Currency Area Properties

JapanEU

USA

SwedenUK

Denmark

EuroArea

USStates


Part Three of Four. Costs and Benefits of EMU.


Costs of EMU

1 Loss of Flexibility: can’t devalue, less autonomous monetary policy forall

2 Asymmetric Effects of macro shocks

PO PC

YOYC

DO

SO

DC

SC

Very open country Relatively closed country


Benefits of EMU

Lower transactions costs

More price transparency

Less uncertainty

More economic growth


Part Four of Four. Wome!


Cool example of EMU: Rome

The first European monetary union was the Roman Empire.

Throughout a geographical area larger than today’s EU, Roman coinscame to be the predominant medium of exchange.

The widespread use of Roman money was due in part to the presenceof Roman occupying forces, but also to the increased amount ofinternational trade across the empire. Rome did not decree its money.

This common currency area broke down around the end of 5thcentury AD.

The single most important reason for the breakdown was almostcertainly the loss of financial and political control by the Romans.

Rising political instability made trade more risky and difficult so thatinternational trade integration fell.


































Next Time

Growth and development effects in the EU. The logic of growth effects,

medium term effects & long term effects.

Baldwin & Wyplosz, Chapter 7.

Badinger, H. Technology and Investment-led growth effects of

economic integration. Applied Economics Letters, 15(7), 557-61,

2008.

Jones, C. I. Introduction to Economic Growth, McGraw Hill, 2008.


economics of european integration - stephen...

Documents