Inflationary Pressure and Labor Conflict

European Economic and Monetary Integration EXAM DATEExam: April 17 at 18.00C401-402-403-404

Decision-MakingThe logic of regional currency calls for a single central agency with strong supranational powers

Fully Dollarized countries cede all powers to the central bank of the country whose currency they useThe relationship is hierarchialNo guarantee that the anchor country will take their views into account when decisions are madeFor instance, ECB and ECCUs central bank ECCB is based on a principle of parity, relationship of equals but the central bank still has the final say

Decision-Making (cont.)Near-dollarized countries have monetary agencies but without significant powers

Currency Board countries have less demanding rules which give them more discretion (not entirely one-sided)Costs vs. BenefitsEconomic FactorsTransaction Costs (favors currency regionalization)Reduction in transaction costs in regionalizationExpenses related to searching, bargaining, uncertainty and enforcement of contracts, currency conversion and hedging no longer neededTrade could increaseLeads to efficiency gainsAlso leads to economies of scale of using a single currencyReduction in administrative costs because a separate structure is no longer needed for a separate currencyA firmer financial sector is established (stability) no big price ups and downs or currency revaluationsReduction in interest rates for local borrowersEconomic Factors (cont.)Macroeconomic Stabilization (does not favor currency regionalization)The loss of autonomous monetary policy to manage the economyGovernments give up control of money supply and exchange rate policy to cope with domestic or external disturbancesDistribution of Seigniorage (does not favor currency regionalization)Spending power that accrues from the states ability to create moneyThis is a pure profit of the central bankIn regionalization governments either give this up completely or divert it to a joint institutionCosts vs. Benefits (cont.)Political Factors

Social Symbolism (does not favor currency regionalization)Money plays a powerful role in helping to promote a sense of national identity Also has a psychological valueMost communities have an emotional attachment to their currenciesThis would be compromised in terms of regionalization

Political Factors (cont.)Diplomatic Influence (does not favor currency regionalization)

Money is command over real resourcesIf a nation can be threatened with denial of access to the means of acquire goods and services it will be vulnerable in geopolitic termsMonetary sovereignty enables policy makers to avoid dependence on some other source for their purchasing power

Costs vs. Benefits (cont.)Taking all five factors into account there are two implicationsIt is clear why so many states still want to produce their own moneyReduction in transaction costs, on its own, would seem unlikely to outweigh the other factorsIt is evident why there is such wide variation in the design of regional currenciesLower degree of regionalization helps to alleviate some of the perceived disadvantagesCosts vs. Benefits (cont.)At issue are state preferences.Although policymakers can be expected to vary the weights they attach to each factor, empirical studies show that 3 conditions are key components in behavior:Country SizeOf all the economies that were fully or near-dollarized the largest was Ecuador a population of about 13.5 millionMost are tiny enclaves or microstatesSmall size also dominates among nations with currency boards or bimonetary systemsCountry Size (cont.)The smaller the economys size (population, territory, GDP...) the greater is the possibility of regionalizationLogic: smaller states are least able to sustain a competitive national currency since these coutnries are already vulnerable in political terms the risks attached to dependence are bearable Indeed, they may even see advange in the protection of an associationPopulations of Fully Dollarized and Near Dollarized CountriesFully Dollarized CountriesNear Dollarized CountriesAndorra71.201Ecuador13.547.510TRNC264.172El Salvador6.822.378East Timor1.062.777Kiribati105.432Kosovo2.000.000Panama3.191.319Liechtenstein33.987Tuvalu11.810Marshall Isl.60.222Micronesia108.004Monaco32.543Montenegro630.548Nauru13.287Palau20.579San Marino29.251Vatican City932Costs vs. Benefits (cont.)Economic LinkagesMany countries that make use of a popular foreign currency have long been closely tied to a market leader economicallyFor ex. EU had deep linkages before the monetary unionThis increases the possibility of government surrendering privilege of producing its own moneyThe higher the level of interaction the more likely we will see economic convergenceCosts vs. Benefits (cont.)Political LinkagesThe intensity of political linkages also effects the decision to regionalizeTies may take the form of patron-client relationshipsFor ex. Ex-colonies often descended from previous colonial relationshipsMajority of fully dollarized or near-dollarized economies and 3 out of 4 monetary unions (other than the EMU) originated in colonial times or in UN trusteeshipCloser political bonds will increase the probability that a government will be prepared to surrender the privilege of a national moneyPolitical linkages reduce the costs associated with the loss of a social symbol and the increase of vulnerability to outside influence

Costs vs. Benefits (cont.)(and a possible 4th condition) Domestic PoliticsMaterial interests of specific interest groups are influenced by what a government decides to do with its moneyTherefore, interest-group preferences are importantThe greater the influence of integrationist interests the more probable it is that policymakers will be prepared to delegate monetary authorityConclusionFuture of monetary governance in a world of regional currencies:Even though deterritorialization of currency is imposing constraints on traditional monetary governance it does not dictate the choice a government will makeThere should be relatively few cases of pure dollarization or currency unification (EMU is an exception) governments will probably prefer mixed modelsConclusion (cont.)Mixed models will depend on the coutnry and its bargaining context

Bargaining context will depend on country size, economic linkages, political linkages and domestic politics

Costs of a Common CurrencyWhen a country relinquishes its national currency, it also relinquishes an instrument of economic policyIt loses its ability to conduct a national monetary policyNation in a monetary union can no longer change the price of its currencyOr determine the quantity of the national money in circulationThe use of exchange rates as a policy instrument is useful because nations are different in some important senses requiring changes in the exchange rate to occurTheory of Optimum Currency AreasPioneered by Mundell (1961), McKinnon (1963), Kenen (1969)

Professor Robert Mundell, 1999 Nobel Laureate: the father of the Theory of Optimum Currency Areas.

Professor Ronald I. McKinnon

Professor Peter KenenOptimum Currency AreasShifts in Demand (Mundell)EU consumers shift their preferences from French-made to German-made products:

Asymmetric ShockAsymmetric Shock

Asymmetric ShockDemand Curve: negatively sloped line indicating that when the domestic price level increases the demand for domestic output declinesSupply Curve: when the price of the domestic output increases domestic firms will increase their supply to profit from the higher price Assumes competition in the output marketsDemand Shift: upward movement in Germany; downward movement in FranceOutput declines in France, increases in GermanyUnemployment increases in France and decreases in GermanyAsymmetric Shock (cont.)There is an adjustment problem in both countries

France: unemployment current account deficit

Germany:

upward pressures on price levels current account surplus

Asymmetric Shocks (cont.)Is there a way to get automatic equilibrium without resorting to devaluations and evaluations?

2 mechanisms:

Wage FlexibilityIf wages are flexible, French workers who are unemployed will reduce their wage claimsIn Germany the excess demand for labor will push up the wage rate

Mobility of LaborWage Flexibility

Reduction of wage rate shifts supply curve downwardIncrease in wages shifts the supply curve upwardWage Flexibility (cont.)Once the French supply curve shifts downward and the German supply curve shifts upward equilibrium is supplied:

French output prices decreaseFrench products become more competitiveDemand stimulated current account deficit improvedOpposite happens in GermanyGerman output prices increaseGerman products become less competitiveCurrent Account surplus is reducedAdjusting for Asymmetric ShocksMobility of Labor

French unemployed workers move to Germany where there is excess demand for labor

This eliminates the need for wage decline in France and wage increases in Germany

Unemployment problem in France solved

Inflation problem in Germany sovled

Current Account disequilibrium dissapears

Asymmetric Shocks (cont.)In the principle of adjustment the problem for France and Germany will dissapear automatically if:

wages are flexible and/or

if the mobility of labor between the two countries is highAsymmetric Shocks (cont.)If this does not happen then both countries have an equilibrium problem (leading to German price increases):Wages in France do not decline despite unemploymentFrench workers do not move to GermanyGermanys excess demand for labor puts upward pressure on wagesGermany must increase prices to adjust to the disequilibriumHigh German prices make French goods competitive againUpward shift in the demand curve of France

Asymmetric Shocks (cont.)If wages do not decline in France the adjustment to the disequilibria will take the form of inflation in Germany

Germany then faces a dilemma:

High inflation OR(to eliminate this they need to use restrictive monetary and fiscal politicies but this will mean) Current Account SurplusCurrent Account Surplus(elimination of this means higher inflation)Asymmetric Shocks (cont.)Dilemma can only be solved by revaluing the Deutsche Mark against the French Franc:This reduces demand in Germany and increases competition for French goods

Currency RevaluationFrance solves its unemployment problemGermany avoids inflationary pressuresCurrent account disequilibria disappears

Currency RevaluationIf France does not have control over its exchange rate because of joining a monetary union with Germany:France will have an unemployment problemAnd a current account deficitThis can only disappear by deflationMonetary union has a cost for France when faced with a negative demand shockGermany will find it costly to be in a uinon due to the inflationary pressuresMonetary Independence and Government BudgetsWhen countries join a monetary union they lose their monetary independenceThis affects their capacity to deal with asymmetric shocksIt also has another implication: it changes the capacity of governments to finance their budget deficitsMembers of a monetary union issue debt in a currency over which they have no control (in the case of the Eurozone - )This implies that financial markets acquire the power to force default on these countriesWould not have been the case had they kept their own currency over which they had control when issuing debtUK vs Spain Fears of Government Debt DefaultUK:In such a situation the price of the pound would drop until investors were willing to rebuy it againUK money stock would remain unchangedIf the UK government cannot find the funds to roll over its debt at reasonable interest rates it would force the Bank of England to provide it with the cash to pay out bondholdersUK government cannot be forced into default because of the Bank of England

UK vs Spain Fears of Government Debt DefaultSpain:Member of the Eurozone debt is in EurosIf investors fear default they sell Spanish governent bonds, raising the interest rateInvestors can decide to take their euros and invest in another euro country (ie. Germany) euros therefore leave the Spanish banking systemThe money supply in Spain shrinks leading to a liquidity crisis for the Spanish governmentThe Bank of Spain cannot provide cash and the Spanish government does not have control over the European Central BankA strong enough liquidity crisis can force the Spainsh government into default financial markets know this and test governmentsUK vs Spain Fears of Government Debt DefaultScenario shows us the fragility of monetary unionsWhen investors distrust a particular member government they will sell the bonds thereby raising the interest rate adn triggering a liquidity crisisThis may lead to a solvency problem:With a higher interest rate the government debt burden increases, the government is forced to reduce spending and increase taxationThis is politically costly and may lead to a defaultBy entering a monetary union member countries become vulnerable to movements of distrust by investorsCurrency Union and Budgetary UnionAnother solution to the asymmetric shock dilemma:Taxes increase in Germany (reducing aggregate demand)Tax revenues are transferred to France where they are spent (increasing aggregate deman)Frances current account deficit is financed by GermanyA budgetary union achieves two things:Creates an insurance mechanism triggering income transfers from the country experiencing good times to the countries hit by bad luckAllows consolidation of a significant part of national government debts and deficits thereby protecting its members from liquidity crises and forced defaultsThis is obviously not a very likely solution

This solution is usually applied to regions of the same nation not between different nations

This is only a temporary solutionFiscal Equalization Between Lander in Germany (2006)Contributing Lander (in EUR mil.)Hesse2,418.0Bavaria2,093.1Baden-Wrttemberg2,056.7Hamburg622.6North Rhine-Westphalia131.6TOTAL7,322.0Receiving LanderBerlin2,709.0Saxony1,078.0Thuringia616.6Bradenburg611.2Saxony-Anhalt590.2Mecklenburg-Vorpommern475.2Bremen416.9Rhineland-Palatinate346.1Lower Saxony239.8Schleswig-Holstein123.7Saarland115.3TOTAL7,322.0MAIN POINTSIf wages are rigid and labor mobility is limited countries that form a monetary union will find it harder to adjust to demand shifts than countries that have maintained their own national moneys and that can devalue (and revalue) their currency

A monetary union between two or more countries is optimal if one of the following conditions is satisfied:

There is sufficient wage flexibilityThere is sufficient mobility of laborMAIN POINTS (cont.)It also helps to form a monetary union if the budgetary process is sufficiently centralized so that transfers can be organized smoothly(The other benefits of a monetary union are yet to be defined)

Different Preferences of Countries About Inflation and UnemploymentCountries have different preferences Some are willing to accept more inflation than othersThis makes the introduction of a common currency costly

Different Preferences about Inflation and Unemployment (cont.)Fixed exchange rate unstable if the two countries involved have different preferences2 countries with different preferences (ex. Germany and Italy) now need to keep a fixed exchange rate and will need to choose another less desirable point on the Phillips CurveThey will have equal inflationItaly will have less inflation and more unemploymentGermany will have more inflation and less unemploymentThis analysis was popular in the 1960s and 1970sPhillips Curve has since seen its demise and is accepted to be unstableDifferences in Labor Market InstitutionsThere are important institutional differences in the labor markets of European countries:Highly centralized labor unions (ex: Germany)De-centralized labor unions (ex: the UK)This may introduce significant costs to a monetary unionInstitutional differences can lead to divergent wage and price developments even if countries face the same problemsEx: oil price shock effect on domestic wage and prices depends on how labor unions react to these shocksDifferences in Labor Market Institutions (cont.)Bruno and Sachs (1985): macroeconomic theory of the importance of labor market institutions:

Supply shocks have different macroeconomic effects depending upon the degree of centralization of wage bargaining

Corporatist (centralized wage bargaining) countries labor unions know about the inflationary effect of wage increasesExcessive wage claims lead to more inflationReal wages do not increaseThey have no incentive to do thisDifferences in Labor Market Institutions (cont.)Less centralized wage bargaining countries know that the effect of individual unions asking for higher wages is small (because they are only a small fraction of the labor force)Free-riding problemEach union tries to increase wages of its members because if it does not their real wages will declineWage moderation following supply shocks is less likely in these countriesNo individual union has incentive to reduce wage claimsDifferences in Labor Market Institutions MAIN POINTSCountries with very different labor market institutions may find it costly to form a monetary union because with each supply shock wages and prices in these countries may be affected differently making it difficult to correct for these differences when the exchange rate is irrevocably fixedDifferences in Legal SystemsDespite integration, member states of the EU have very different legal systemsSometimes these differences can have important effects on the way markets functionExamples:Mortgage markets: legal systems regarding mortgage markets differ from one state to the nextSome states offer more protection to banks extending mortgage loansThis gives a different amount of risk to mortgages according to which country they are in100% collateral required in some countries while in other countries substantially less collateral is requirednterest adjustments are also subject to legal differences where mortgages with floating interest rates exist in some countries and mortgages with flexible interest rates exist in other coutnriesIncrease in interest rate by the ECB will have different effects in different countries of the union

Differences in Legal System examplesCompany FinancingCompanies differ in how they finance themselvesCountries with an Anglo-Saxon legal tradition: firms go directly to capital markets (bond and equity markets) markets are well developed and very liquidCountries with a Continental European legal tradition firms go to the banking system for financing capital markets are less developedInterest rate disturbances are transmitted very differently among member statesIncrease in interest rates:Anglo-Saxon system: large wealth effects consumers because they hold lots of bonds and stocks (increase lowers bond and stock prices and wealth declines)Continental system: less effects (consumers will mainly be affected in their bank-lending spending) increase means borrowers are unable to borrow all they want or none at allDifferences in Growth RatesSome countries grow faster than others

Average Yearly Growth rates of GDP in the EU, 1981-1998 (as %)Austria2,2%Belgium1,76Denmark2,13Finland2,34France2,00Germany2,17Greece1,75Ireland5,14Italy1,81Netherlands2,37Portugal2,62Spain2,55Sweden1,56United Kingdom2,26Differences in Growth Rates (cont.)These differences in growth rates could lead to a problem when countries form a monetary unionImports of one country will grow faster than its exports leading to a trade balance problemIn order to maintain its goods more competitive a country has 2 options:Depreciation of its currency not available to countries in a monetary unionLower rate of domestic price increases relative to the other country in question requires a country to follow deflationary policies constraining the growth processDifferences in Growth Rates Main PointsA monetary union has a cost for a fast-growing country it would find it more advantageous to keep its national currency to have the option of depreciating it when it finds itself in unfavorable trade account developments