IF Lec 4: Optimal Currency Areas, Chinese ER regime

What are the qualifications made by the "new" theory of OCA with regards to an increase of benefits as compared to the traditional view ?

*A. Increased credibility of anti-inflation policy: mitigating the time-inconsistency issue and "borrowing anti-inflation credibility"* Barro and Gordon (1983): "time-inconsistency" in monetary economics. Governments have an incentive to renege on their engagement of keeping inflation low and thus have an incentive to create surprise inflation (in order to reduce real wages and stimulate economic activity). Private agents know this and therefore will increase their inflation expectations when negotiating wage contracts, etc. Disinflation attempts then will become more difficult and more expensive in economic and social terms. In fact, countries of which monetary authorities have a reputation of having intensively pursued inflationary policies in the past find it hard to shed that reputation unless they are prepared to undergo a long and costly process of disinflation. E.g., they have to raise interest rates higher than when they would have had higher credibility in order to prove their determination. Joining a monetary union or currency area could be superior: "tying one's hands" by abolishing independent domestic monetary policy through joining a currency area or a monetary union with a low-inflation country whilst allowing for capital mobility (cf. the incompatible trinity). This will allow the domestic authorities to "borrow anti- inflation credibility" and achieve disinflation at lower economic and social costs. Engaging in a currency area or monetary union then allows the domestic country to disinflate at a lower cost. This beneficial effect increases the benefits of engaging in a currency area when compared with the traditional view. [Inflation is lower when you are part of a MU. Why ? Because of higher competition, so lower prices. Thus upon entering a MU, there is anti-inflation credibility. This has to do with the fact that the market share of firms goes down, so that prices go down. Competition increases within the union, among the member states. On the other hand, if one of the countries are subject to inflationary pressure, you cannot disinflate because of the absence of monetary tools (traditional theory). According to the new theory, if there are inflationary pressures, you cannot do anything and monetary policy could not anything anyway. That can be beneficial as well, according to the new theory: you can avoid the wrongdoing of monetary policy (for instance, debt monetisation creates money, thus triggers inflation and depreciates the currency, and the other way around for money withdrawal). If you become part of a MU these wrongdoings can be avoided, which is good.]

What are the qualifications made by the "new" theory of OCA with regards to an increase of costs as compared to the traditional view ?

*A. Low labour mobility under conditions of uncertainty* Labour mobility is decided by taking account of the costs of moving and the uncertainty concerning the labour income. This leads to the phenomenon of hysteresis such that within a range of expected income differentials, no labour mobility will arise due to the sunk costs of moving. Phrased differently, labour mobility will only arise if the expected discounted lifetime earnings abroad are above the expected discounted lifetime earnings at home augmented by the sunk costs of moving. If moreover labour income is more uncertain, labour mobility obviously will be even lower. This will be relevant within a currency area since it can be expected that uncertainty of labour income in a currency area may increase (cf. the use of the traditional instruments of macroeconomic policy to counter the effects of asymmetric shocks is severely constrained). Labour mobility according to the new insight thus is suggested to be lower than what was previously expected such that the costs of engaging in a currency area are higher than what was previously expected.

What is McKinnon's stance on RMB flexibility ?

*McKinnon: "little" flexibility is advisable* • An appreciation of the RMB is anyway unlikely to decrease the Chinese trade surplus: - The highly criticised Japanese trade surpluses of the 1980s did not decrease after the sharp appreciations of the yen in that period - The surpluses of China are predominantly due to the fact that Chinese wages are (far) below US and European wages [Cost of production in China leads to lower prices of those goods, not the ER per say. Believing that it is only the ER that is the source of the damage, it is what makes Chinese goods more competitive means believing in the law of one price. You then believe that making the ER appreciate will make the price of Chinese products will go up; yes, it will increase, but to not to that extent: the pass-through is not full.] - Even if appreciations of the Renminbi would decrease exports, they could also drive down imports and fail to reduce trade surpluses. Reasons: • They could also slow down GDP growth and then may well slow down import growth [Nobody wants this.] • FDI inflows into China as well as domestic Chinese investment may decrease and drive down imports (through enhancing productivity, hence Balasssa Samuelson effect) [Decrease in FDI is not a good sign because it means that in the longer run, there might be a slow down in the trade competitiveness of the country: FDI increase productivity, lowers the prices of goods, and makes goods more competitive internationally. Everybody loves FDI.] • They would have wealth effects (cf. the capital losses on the foreign-exchange reserves) that also would depress imports [This is related to the cost of having a higher foreign exchange reserve. Allowing the currency to appreciate makes the value of the balance sheet of the Bank to go down: negative wealth effect.] [What happens to the trade balance does not only depend on the ER regime or the value of the currency, it depends on many factors. The CA is nothing else than the difference between savings and investment. An economy might be running a CA deficit because it is a dissaving economy. If savings go down, then even if the currency is depreciated, the economy is dissaving. This is translated into increasing the value of your currency implicitly. For example, Japan is experiencing an effective RER depreciation but the CA deficit keeps on increasing. Because the age of the population goes up, which is when the econ is dissaving. the econ consumes more than it saves. Consumption grows more than savings, which puts downwards pressure on the trade balance. What happens to trade internationally depends on many factors, including ageing. An econ that is dissaving triggers a trade deficit. ]

What is Roubini's stance on RMB flexibility ?

*Roubini: "more" flexibility is advisable* • Stronger appreciations would be advisable from a political-economy point of view as they could defuse potential protectionist reactions abroad [Not only about the ER. It is about labour costs, input of production costs that trigger cheaper Chinese products. Also to avoid over-accumulation of foreign exchange reserves.] • As only 50%-70% of these interventions are sterilised, the Chinese money stock continues to grow. This contributes to: - Inflation - The creation of excessive liquidities that fuel credit growth, investment booms and asset bubbles • Appreciations of the Renminbi would decrease China's dependence on exports and would step up domestic consumption: - Appreciations would encourage consumption (price of importables decreases) - Consumption is less volatile than exports (cf. Chinese exports decreased by 16% between 2008 and 2009). [Proponents of appreciations base that on improving the purchasing power of Chinese consumers. It would boost consumption, with the obvious effects on GDP (it boosts growth). Chinese exports decreased in 2008, it was triggered by the slowdown in world demand, not by appreciations. Argument here is that more appreciations are allowed because that would not hurt China: the benefits would be more than the costs. Even though it could hurt the trade balance a bit, this would increase consumptions because of wealth effects on consumers due to improving purchasing power (domestic side). Yes, there might a drop in exports, but the increase in consumption that would be triggered could work in the opposite direction and undo the negative effects of the appreciation on international trade.] • Appreciations in the future will anyhow be unavoidable as the equilibrium real exchange rate in emerging market economies appreciates (cf. the Balassa-Samuelson effect). Postponing appreciations of the nominal exchange rate will then lead to: • Larger and sharper future appreciations that may well be more disturbing • Even larger capital losses on the stock of foreign-exchange reserves. Indeed, limiting appreciations now requires further accumulation of foreign-exchange reserves such that the latter stock increases and future capital loss will then become even more substantial. [The appreciation of the RER caused by inflows of FDI (BS effect) could trigger appreciations of the NER in the longer run, so further appreciations by the PBC of the NER would be unavoidable, and so this is nothing to worry about] • Additional elements (not mentioned by Roubini): - The artificially low RMB obviously affects allocation of capital. In fact, the implicit export subsidy encourages investment in exportables. Problems: • Excessive capacities in the export sector may well arise • Exports are more volatile than for instance nontradables - The burden of the implicit export subsidy is borne by the part of the populace that cannot hedge inflation risk (i.e., the poorer part of the population), which further increases income inequality [What is important is that the value of the currency over which the gov and monetary authorities agree upon also has indirect effects: the wealth effects (inherent to a change in the value of the currency against the one the authorities are pegging to), effects on the balance sheets of firms, and the induced effect of foreign consumption on our goods. Direct effects: prices of goods at which we are importing or exporting.] - Larger appreciations reduce import prices and help in fighting inflation (controversy between China's Ministry of Finance and its Ministry of Trade) [Depreciating pressures on the currency, which in China are triggered by the authorities (while markets put appreciating pressures), are always inflationary. Why ? Because depreciating pressures boost exports, to increase output, boost domestic GDP, which causes inflation. And depreciations imply higher costs in production, translating into higher prices for goods, as well as higher prices for imported goods. This all leads to inflation.]

What are different types of ER regimes ?

- Floating - Fixed - Managed float: authorities allow currency to fluctuate, but control the rate with which currency depreciates or appreciates - Crawling peg: allow currency to fluctuate within bands, intervene when outside of the band

What is the Incompatible trinity ? What is the consequence of it for a fixed ER regime ? What is China doing to keep devalued currency ?

- Free capital mobility - Fixed ER - Independent monetary policy Cannot have the 3 at the same time. If fixed ER, then monetary policy not independent, and/or capital controls required. Monetary policy not independent because you have to fix interest rate to move with the foreign interest rate, and thereby shut down the channel that arises because of interest rate differentials. Why ? Comes from UIP. Take fixed ER regime, and say that monetary authorities are fixing the value of the currency to 1. With logs, taking the UIP, you get that you need to fix the domestic interest rate to the foreign interest rate. Simply because you want to shut down the interest rate differential. Or: you impose capital controls. China has done so, because it wants to avoid appreciating pressures to the currency. China controls capital inflows, while outflows are free. Inflows tend to appreciate the currency. The Chinese authorities are thus taking measures to fight the appreciating pressures to the currency, to keep international competitiveness of their goods. ]

Define Currency Areas. Cite a few examples (except the euro area) of CAs. Describe the difference a CA and a MU. Define an optimal currency area.

1. A currency area is a domain within which exchange rates are fixed. One can here distinguish further between the currency area and the monetary union. 2. Currency area • Irrevocably fixed exchange rates • Capital mobility • Common monetary policy of the members [Before the formation of the Euro area, there have been other currency areas (although monetary policy was not shared). Currencies fixed against a benchmark: - ER mechanism - Bretton Woods - Asian countries: fixed against a basket of currencies These currency unions collapsed in the wake of crises, because monetary policy was not shared, like in the EU. ] 3. Monetary union • Common (or single) currency • Capital mobility • Common central bank: - ECB takes monetary decisions - But regional CBs vote, and contribute to the debate on monetary policy Note: The names "currency area" and "monetary union" are often used as synonyms. For instance, the concept "optimum currency areas" is also applied to the European Monetary Union, which went beyond the currency area and has developed into a monetary union. This course will follow this practice and thus disregard the conceptual difference between currency area and monetary union. 4. Optimal currency area/monetary union For a country, the optimum currency area/monetary union is realised within that group of countries for which the positive difference between benefits and costs of monetary integration is maximised. The benefits are maximised compared to the costs. The benefits and the costs are defined by the approach you take as an economist.

What are the additional benefits of belonging to a MU ?

1. Increase in the aforementioned benefits of the currency area: • Exchange rate uncertainty completely disappears since there simply is no longer an exchange rate • Transaction costs due to foreign exchange market operations are now completely abolished (for the EMU countries this benefit was estimated at 0.25%-0.5% of GDP) • Full transparency of prices since prices now are expressed in the same currency • Increased depth and width of financial markets since they now use the single or common currency. This further improves allocational efficiency in the financing process. 2. The common currency is legal tender in a larger area, so money can perform its functions better (larger economies of scale in the use of the common currency). For instance, having a single or common currency reduces costs in terms of accounting, handling and collecting of information. [Legal tender: currency acts a legal tender, in the sense that most of the domestic reserves (within the MU) are now in the common currency. Before joining the MU, CBs of countries that later on joined had to accumulate foreign reserves from other countries, to ensure against currency attacks or crashes (any risk that might come up on financial markets). Now, they do not have to do that. ] 3. Savings on international monetary reserves within the single central bank of the monetary union: • The sum of the (mutual) balance-of-payments imbalances between the individual member countries no longer has to be "backed" by foreign-exchange reserves at the level now of the central bank of the monetary union. This lowers the (costly) official holdings of monetary assets. Example: the need for holding foreign- exchange reserves for backing balance-of-payments imbalances between the Netherlands and Germany has disappeared. • Less monetary reserves must be held in order to be able to cope with speculative capital. Example: Before the start of EMU, all individual future member states of EMU had to hold foreign-exchange reserves in order to be able to cope with (potential) speculative attacks on fixed exchange rates. • The need for reserves at the European Central Bank is also lower because of the fact that the European Central Bank does not pursue an exchange rate target unlike the individual EMU members did in the past. [This relates to the previous point: foreign reserves are no longer needed. Also, the ECB itself does not do any foreign reserve policy: it is a big region, and the currency is not subject to risk. You do foreign reserve policy when you want to defend your currency: small, open economies accumulate foreign reserves, in case there is a currency attack or a collapse of the financial system. For instance, the Bank of England do accumulate some foreign reserves (however not much because it is a strong currency, of an economy that does well, so foreign reserve policy not done to the extent of other, smaller, more at risk economies, like Asian countries). Important, because of the literature on the "Twin D's" (Default and Depreciation): - Many countries have large inflows of capital which means that they have investors buying government debt. - When their currencies depreciate, this means that the value of their debt increases. - In this case, it is very likely that the government will default. - When in an MU, this risk no longer exists. Small, open economies used to follow a foreign reserve policy, in order to ensure themselves against these events, the potential of these events.] 4. Wider and deeper foreign-exchange market: more stable exchange rate and less influence of speculators. Example: the influence of an individual speculator on the Dutch Guilder obviously was far larger than the influence of that same speculator on the Euro. [The bigger the size of an economy, and the stronger its currency, the less necessary it becomes to follow a foreign reserve policy, because the power of a single investor to affect the value of a currency also goes down. There is no currency attack on the US dollar, or the euro, only on pegged currencies or small open economies (e.g. Asian countries). When a country has enough foreign reserves, a currency attack is less likely to make that currency collapse. They serve as a buffer for your currency and guarantee the stability of your currency, when you are a small open economy. These are issues you no longer need to worry about when you are part of a MU. 5. Possibly a larger amount of seignorage through the increased international use of the Euro. Foreigners can hold part of their reserves in the common currency and the common currency can even be used a legal tender outside of the monetary union (e.g. the Euro is legal tender in Kosovo and Montenegro since January 2002)

What are the additional costs that arise when member states are part of a MU (shared currency) ?

Additional costs when a common currency exists (monetary union): • Loss of seignorage at the national level in a currency union. [Monetary policy is not independent] • The changeover costs of switching to a new currency • The administrative costs of establishing a new supranational monetary authority [legal issue] • What is the correct exchange rate level before joining the Union? When you are a member-state and you want to join the MU, what kind of ER do you agree upon ? [What is the value of the currency (ER) that you agree with the MU to fix your currency to before you enter ? If you fix the wrong value, it may happen that your citizens, once you join the MU, their purchasing power goes down. The ER with which you are fixing your currency is very important, because fixing your ER has immediate impact on the prices of goods that the consumers can buy. You are not fixing the wages but the currency, meaning an immediate impact on the prices. The wrong value might hurt consumers (purchasing power) and trigger a downturn in the economy.]

What sort of capital flows are restricted by the PBC ? Why are these capital flows specifically restricted ? Why should China be slow on capital account liberalisation according to economists ?

China applies selective capital controls on capital flows: in- and outflows of FDI are largely liberalised, however strict controls exist for portfolio flows and bank loans. [Need capital controls to guarantee a given value of the currency, because you need to secure the value of the currency against the behaviour of investors who might affect the value of the currency towards the direction which is at odds with the direction you are targeting as a central bank. See B-S effect: FDI (boosts productivity and improves purchasing power of currency, terms of trade effects) does not affect the NER but the RER: they are inflationary. They do not affect the value of the currency in nominal terms. Portfolio investments (second part of the capital account) is what we call hot money investment and affects value of currency in nominal terms only. This is why there are controls over portfolio investments. These will weaken because of the WTO: you secure agreements about shipping costs, transaction costs, but are subject to conditionality over which controls you might impose on capital flows. Part of China's controls will thus have to be removed.] Such controls will anyway weaken due to the obligations that China has taken on when joining the World Trade Organisation (WTO) in 2001. Most economists argue that China should be slow on capital account liberalisation. Reasons: • Restrictions to capital mobility allow for independent monetary policy together with an exchange rate that is relatively "stable" (read: appreciating at a moderate pace) in line with the insights from the incompatible trinity. [The removal of cap controls should be associated with the adjustment of ER management: those two should be combined. This is because, if the removal of some cap controls is not associated with authorities being less strict on the ER target, then monetary policy has to be adjusted to a large extent to guarantee the value of the currency. A big part of the job of fixing the currency value is done by capital controls. Taking those out will impose a larger and larger burden on monetary policy, which might put China at risk, which nobody wants.] • Substantial inflows could arise due the higher interest rates and returns, and the expected appreciations of the Renminbi. Such inflows could add to credit growth, increase the amount of non-performing loans (NPL) and ultimately endanger stability of the financial sector even further

What is, generally, the advisable degree of flexibility in the RMB value (especially critic from the US regarding RMB value) ?

Especially the US wants China to appreciate the RMB faster. Argument: the undervalued RMB increases Chinese exports to the US. [This can harm American exports, and possibly also American import-competing producers, so China harms production in the US, putting a hold on growth. The other issue is the trade balance, which has the twin deficit: on the CA and the budget balance. Having cheap Chinese products does not allow the economy to decrease the CA deficit. On the other hand, argument that US firms use inputs used in China (e.g. iPhones parts). Letting the RMB appreciate induces higher costs to American firms, which also import intermediate goods. ] The wording of the official stance of 19 June 2010 indicated that basically any degree of flexibility would be compatible with that declaration.

What are the benefits of participating in a CA according to the traditional view ?

The benefits of participating in a currency area are situated more on the *microeconomic level*, whereas the costs (see Section 2.2) are situated rather on the *macroeconomic level*. - Main cost (macro): you have to give up the independence of your monetary policy (cannot use interest rate to counteract inflationary pressure, boost the economy, when there is a pressure of a contraction) Benefits of CA (irrevocably fixed ER): 1. *Exchange rate uncertainty and exchange rate volatility disappear.* This is expected to boost production, international trade and foreign direct investment. Indeed, returns from producing, selling and operating abroad become more predictable and one can assume economic agents to dislike exchange rate uncertainty. [Portfolio Argument: Important because many member states used to have debt that was denominated in currency of other member states, or they were themselves exposed to debt of other countries, denominated in that country's currency. Before the formation of the Euro area, Italian debt was held by Germans and vice versa. Implies you are exposed to currency risks: if the Italian lira collapses, the value of your portfolio is going down as a German. Portfolio holding in general are part of the argument. Goods market argument: Argument about goods market, regarding PPP. In the euro area, the international trade of goods is easier because there is no arbitrage, no currency risk. Common monetary policy means that prices will converge on the longer run. Provided real wages adjust, this means purchasing power converges across the union. No wealth inequalities within the union. ] 2. Transaction costs due to foreign exchange market operations decrease (including in-house costs for businesses). For instance, bid-ask spreads typically decrease when exchange-rate volatility decreases. [TCs (transportation costs, related to tariffs, trade protectionism measures that member states within EU were adopting, making trade in goods and services riskier and at a higher cost, and that was reflected in higher prices) are now either lower or do not exist at all.] 3. Higher price transparency. Prices become more comparable since foreign prices can now simply be "translated" into domestic-currency terms via multiplication by a constant exchange rate. This will decrease market segmentation, encourage international price competition and therefore stimulate more efficient production, microeconomic efficiency and resource allocation. [Higher transparency, because everything is voiced in the same currency, there is a clear picture as regards to the costs firms are facing when it comes to pricing their goods.] 4. Financial markets grow deeper and wider. Financial markets grow deeper as their size increases and grow wider as more and more new financial instruments can be developed since currencies are linked to each other by a fixed multiplicative constant. This improves allocational efficiency of the financing process and thus can lower capital costs, production costs and subsequently gives lower prices to the consumer. [This has to do with TCs, and the fact that there is no currency risk. It is easier now, and less risky, to diversify your portfolio by investing in assets issued by member states that are part of the MU, without being exposed to the currency risk. So financial markets becomes much more competitive, the volume of transactions is higher, and the currency risks are not there anymore, as in the past.] 5. Economic openness of the currency area is lower than that of the individual member countries Lower openness implies that exchange rate volatility with non-EU countries will have less of an impact on the economies of the individual member countries. [It's been observed that most of the member states of the MU became more competitive in their goods market, as such the degree of openness improved. This comes at a cost in terms of the trade balance, because home bias (preference towards consuming domestically produced goods instead of foreign goods) goes down, so the substitutability between home and foreign goods goes up. Hence, you can switch expenditure between foreign and domestic goods more easily within MU, boosting competitiveness in goods market. So consumer surplus goes up (when the degree of competitiveness goes up) within the union, and prices go down by definition. Also on top of that, especially when you are a small country, openness increases and exposure to risks related to what happens outside the MU goes down, because the euro area as a whole is much less open that the member states themselves, individually. Trade within the union is very easy, because there are no borders, no barriers to trade, but at the same time, the euro area itself exhibits more home bias than the states themselves (which prefer to trade with each other than with the rest of the world). So trade within the euro area goes up, while trade with outside the euro area goes down. The EU trades very little with the rest of the world, compared with what member states do. This is very similar to the US situation. ]

What does the endogeneity of the OCA, according to the new theory, entail as compared with the traditional view ?

The traditional OCA criteria are criticised as being backward looking (countries had to fulfil certain criteria before joining the union): A. The traditional view argued that inflation convergence is a precondition for engaging in a currency area. However, becoming member of a currency area may mitigate the time-inconsistency problem such that inflation convergence can be a result or outcome of becoming member of a currency area. B. The traditional view argued that high degrees of openness and goods market integration should be a precondition for engaging in a currency area. However, becoming member of a currency area may cause: • Increased openness and goods market integration due to the fixed exchange rate / common currency that decreases trading costs, increases transparency and competition. • Increased similarity of shocks which then reduces exposure to asymmetric shocks or causes stronger synchronisation of business cycles (cf. the stronger goods market integration). This can make OCA endogenous: countries that adopt an irrevocably fixed exchange rate or a common currency will obtain stronger inflation convergence and stronger business cycle synchronisation after having adopted that fixed exchange rate or common currency. Phrased differently, the currency area will develop into an optimum currency area. [The new theory says countries do not need to fulfil any criteria since convergence happens upon joining. This is what is meant by endogeneity of the OCA: the union becomes optimal by itself. It boosts competition, you do not have to worry about monetary or fiscal policy or any kind of distortions, so it strengthens convergence across member states. But graph: Germany, France, Italy and the EA synchronised their business cycles before entering the MU, which is evidence against the new theory. This has externalities for other countries outside the EA (UK and US) which are main trade partners. Synchronisation in international trade usually coincides with synchronisation of the business cycle.]

What are desirable characteristics of member countries of a CA according to the traditional view ? -Optimal Currency Area (OCA) desirable characteristics according to the traditional view of CA

Theory has drawn up a list of characteristics that minimise the costs of becoming member of a currency area or of a monetary union. The following list of desirable characteristics represents the traditional view on the so-called Optimum Currency Area (OCA) criteria. (i) Similar rates of inflation to guarantee stable real exchange rates. Higher inflation in the domestic country yields real appreciation, deterioration of international competitiveness, widening current account deficits and ultimately the demise of the fixed nominal exchange rate. (ii) High degree of mobility of factors of production including labour mobility (the Mundell criterion). When the traditional instruments of macroeconomic policy cannot or only insufficiently be used to offset the effects of asymmetric shocks, mobility of the factors of production can alleviate social costs. [What is important upon participation to a MU, is basically to increase the mobility of factors of production. In the Euro area, there is increased mobility of factors of production, but it is one-sided: from the South to the North. This is not good, because this causes faster productivity growth for northern countries compared to southern ones. The reasons behind this is that economies in the South are not doing as well as economies in the North. This has implications for labour mobility and therefore on the productivity of labour. This dampens labour productivity in southern economies. Why is this bad ? Because productivity is aligned with wages. When productivity goes down, (real) wages will go down too. Purchasing power, and thus consumption, go down. This thus harms the recovery of an economy. ] (iii) High openness (and small size) of the economy (the McKinnon-criterion). Fixed exchange rates stimulate trade and open economies are affected more by volatility in exchange rates such that small and open economies should favour having fixed exchange rates. (iv) High degree of commodity diversification in the economy (the Kenen-criterion). Diversified economies are better able to deal with asymmetric shocks because asymmetric shocks typically tend to affect specific sectors and/or products (e.g. semiconductors). Higher degrees of commodity diversification then reduce the nation-wide impact of asymmetric shocks. [Comes on top of higher openness. Implies also higher stability and expenditure switching effect. The result is improved competitiveness upon joining a monetary union.] (v) High degree of price and wage flexibility. When the traditional instruments of macroeconomic policy cannot or only insufficiently be used to offset the effects of asymmetric shocks, flexible prices and wages can mitigate the economic and social effects of asymmetric shocks. For instance, the sectors that are hit by a negative asymmetric shock (e.g. foreign demand for the product drops unexpectedly) can regain international competitiveness when prices and wages display downward flexibility. (vi) High degree of goods market integration between countries. Those countries are more similar and thus are more likely to be hit by symmetric shocks and thus be less likely to be hit by asymmetric shocks. This then will reduce the cost of losing the main instruments of macroeconomic policy. (vii) High degree of fiscal integration. A system of budgetary transfers between countries that have a fixed exchange rate towards each other could neutralise the negative effects of asymmetric shocks by directing fiscal transfers from the countries that are favourably affected to the countries that are negatively hit. [Stability and Growth Pact prescribes this, so that economies converge in terms of deficit, debt. In the NL taxed are high but tax rebates are also high: healthy fiscal policy from government] (viii) Low historical variability of the real exchange rate. The above characteristics are difficult to quantify such that an easy-to-quantify summary variable (a "meta" OCA criterion) was looked for. Countries with historically low variability in real exchange rates are good candidates for establishing a currency area. It highlights that for these countries the need for the exchange rate instrument to offset the effects of asymmetric shocks was small in the past and also can be expected to remain small in the future. In the same vein, some proposed similarity of (economic) shocks and thus similarity of business cycles as a "meta" OCA criterion. [RER is ratio of prices in the case of two EU countries. Because of a higher degree of competition, firms have less degrees of freedom to change their prices and as such, prices become less variable and therefore the RER becomes less variable as well. But the less variable RER means that the purchasing power of countries does not change that easily. ] (ix) Large political will/political integration. Countries that display a strong political desire to form a currency area and/or that are politically (strongly) integrated are excellent candidate member states since they have already signalled their will to severely curb the use of the traditional instruments of macroeconomic policy. [Some member states love the benefits but hate the linked costs of a MU (e.g. UK).]

What are the costs of participating in a CA according to the traditional view ?

Whereas the benefits of participating in a currency area are situated more on the microeconomic level (firms pricing their products, the way monetary policy is conducted, the way financial markets operate, investors, etc), the costs are situated rather on the macroeconomic level. The costs relate to the loss of the main instruments of macroeconomic policy when the country in question is hit by an asymmetric, i.e. country-specific, shock. This type of shock affects only one of the member states of the currency area or only affects a subset of the member states. [Each member state need to give up its sovereignty: monetary policy. Although each country is ensured, isolated from currency attacks, risks in financial markets, international goods markets, they cannot use monetary policy to boost their economy. the CB cannot monetise debt anymore, interest rates cannot be lowered, or increased, depending on the kind of pressures, but the only thing that they do have (and this is not entirely up to the government) is fiscal policy. Some believe that the fact that we do not have a fiscal union, a single fiscal authority, means that fiscal policy is independent, while this is not the case: countries can choose the mix (taxes, spending) to guarantee a certain level of deficit, or the sustainability of debt, but the amounts are set (3% maximum deficit, 60% debt-to-GDP ratio). The number of countries that obey is limited, but there are rules (some sort of fiscal union. This union does not prescribe the recipe, there is no specific rule for that, but the targets are the same. The question is then, il this important or not in normal or not ? Until the crisis, everything was going smoothly: it is good when times are boring. When times are not good, you need to take a stance, and it might be very difficult because countries might be hit by asymmetric shocks. The crisis did not hit all countries to the same extent. Even if they were affected to the same extent (as measured by a drop in GDP), the drop of GDP was not fuelled by the same factors. For example, in Ireland it was the banking system that collapsed; in Greece the unsustainable government debt; in Spain it was the housing market, mortgages. In the NL there was nothing; Italy, combination of debt and baking sector. This is the moment where having monetary policy described by the use of interest rate is not enough: we need to improve the tools of the common policy, monetary policy. And we need to guarantee that all member states stick with the same fiscal targets, and obey them. They have to abide by the rules. This is why, nowadays the discussion about monetary policy is not about interest rate changes, but is about using the balance sheet, using forward guidance as regards to what is the intended use of monetary policy so that agents have more information, the target being that agents have better expectations. Most CBs nowadays do forward guidance. Forward guidance is one of the tools the necessity of which came up during the crisis, it is part of the lessons learned during the crisis. The ultimate purpose is to make sure that when member states are hit asymmetrically by a shock (even though monetary policy is common), we have the tools to smooth out the asymmetric ways with which countries are hit by shocks. The fundamentals were different between member states when the crisis hit; this is one of the issues of the EMU. Debt-to-GDP was not the same, labour markets were not equally competitive, the productivity of labour as an input was not the same, the purchasing power among member states was not converging. These are issues that you do not see when things are going well. ] If a negative asymmetric shock hits the economy and increases unemployment, a crucial difference arises in the potential policy responses: • If the country has not chosen for an irrevocably fixed exchange rate or a common currency, the increased unemployment can be reduced by altering the exchange rate, the interest rate and/or by using fiscal policy. • If the country has chosen for an irrevocably fixed exchange rate or a common currency, the use of the main instruments of macroeconomic policy is ruled out or at least severely limited (see below). [Graph: as countries get close to the date at which they join the EMU, there is a convergence in the interest rate paid by governments paid, and almost perfect convergence in good times. Then, divergence after crisis. What are you left with when there are such asymmetries ? The asset-purchase programme of the ECB was very successful, in reducing these asymmetries here. It led to a drop in term premia that governments used to pay, a drop in the long term rates, and made it cheaper for governments to borrow. This led to a lower interest rate in borrowing of the private sector. This is the moment where you realise that monetary policy is successful in reducing these asymmetries here, but you need additional measures to guarantee that the financing by the ECB transmits into the real economy, through boosting investment. The way the asset-purchase programme transmitted into the real economy is twofold: - Fiscal channel: governments now can borrow cheaper, so this leaves fiscal space for governments to cut taxes. - Credit channel: lower interest rates by the government imply also lower corporate interest rates (because the ECB also bought corporate bonds), so financing opportunities become cheaper, so firms can boost demand for labour, production, and so on. Commercial banks were no longer exposed to risk due to higher government interest rates, so they could boost loans to the private sector. Then you need macro-prudential policy, which is the policy that guarantees that part of the financing that commercial banks get from the central bank is transmitted to the economy in the form of loans. This is why monetary policy alone is not enough, you need additional tools. Asymmetries led to new measures to guarantee that asymmetries die out over time; the ECB has been very successful in doing that. ] More in particular: 1. No longer the possibility of defining an autonomous national monetary policy (cf. the fixed exchange rate together with capital mobility rule out independent monetary policy as shown within the incompatible trinity) This has the consequence that the individual country can no longer use the interest rate instrument to counterbalance asymmetric shocks and it also implies that the country can no longer choose its desired mix between inflation and unemployment (i.e. choose the desired point on the Phillips curve). 2. No longer the possibility of utilising exchange rate adjustments to counter the effects of asymmetric economic shocks. 3. The use of expansionary fiscal policy is (severely) restricted since increasing budget deficits reduce the credibility of the irrevocably fixed exchange rate or the common currency and this risks, together with capital mobility, to cause potentially disturbing capital flows. Also for that reason, institutional arrangements may explicitly restrict fiscal policy (cf. the Stability and Growth Pact in the EU that limits budget deficits to 3% of GDP).

What is a sterilised intervention ?

[ Let's say you want to appreciate your currency: withdraw currency (reduce money supply). This implies appreciating pressures to the currency, and upward pressure on the interest rate. In the case of a fixed ER regime, or controlled like China, you want the interest rate to remain stable. You thus want to undo this effect, so print money, with which you finance government debt, which forces the government to issue more bonds, tending to motivate saving, decreasing the demand for the currency, and sends the interest rate back to where it was. But the stock of domestic currency in circulation has gone down. This is a full sterilised intervention. An intervention can be partially sterilised. Part of the increase in interest rates is undone. In the case of the PBC fixing its ER, in the goal of fixing the interest rate after money supply increase: - Money supply increasing because of purchase of foreign assets (to counter appreciating pressure), downward pressure on interest rates - MS moving to the right, lower interest rate, this effect (or part of it) has to be undone - Allow demand for money to increase or cut money supply back in order to undo interest rate pressure effect - Solution: cut money supply back by throwing money back into the market, but not to banking sector (and then to be provided by banking sector through new loans, etc); use this money just to finance government debt, which is money that should stay with the government to pay back part of its debt, so it is not money that is thrown away into the market - Intervention where the increase in MS does not end up into the market, but is kept with the government In practice: - Buy debt held by government denominated in foreign currency, and thereby increase money supply (withdraw foreign reserve, increase supply of domestic currency) - In exchange, give domestic currency to government - Then government uses this amount of money to pay back part of its debt and does not use it to boost expenditure or cut taxes and so on - The increase in money supply does not end up into the market, it is kept with the government] - In practice, the PBC does not sterilise all its interventions In the case of a sterilised intervention having as a goal the fixing of the monetary base: 1) Buy foreign currency assets on markets to depreciate currency value by injecting money in (downward pressure on interest rates) 2) Sell domestic government bonds to withdraw money from the economy (upward pressure) In the end, the currency appreciates, while interest rates do not move (as the money supply does not change in the end). (See International Economics book worst comes to worst)

What are the qualifications made by the "new" theory of OCA with regards to a reduction of benefits as compared to the traditional view ?

[All the benefits that accrue to the traditional view of an OCA relate to frictions: labour market frictions, stickiness in prices because of lower competition/higher market power. Now that these frictions do not exist, many of the benefits of being part of a MU no longer exist because of distortions on which those benefits rely. Thus the benefits are smaller when you become part of MU, according to the new theory of OCA.] *A. Link between exchange rate volatility and trade flows* Early assumption: exchange rate volatility hampers trade. However, the empirical literature has not found strong support for this theoretical prediction such that the benefit of having a fixed exchange rate appears to be smaller than what was previously expected. Some reasons for the empirical finding: • Volatility of one currency may not be that important if firms are involved in many markets such that a decrease in the value of one currency on the overall level of the firm may be offset by an increase in the value of the other currencies. • Higher volatility increases the likelihood of exchange rate movements that negatively affect profits, but it also increases the likelihood of strongly favourable exchange rate moves (analogy to financial options of which the price is positively related to the level of volatility). [According the new theory, the risk does not exist because what moves ER are fundamentals. Thus firms are not exposed to ER risk.]

What are the qualifications made by the "new" theory of OCA with regards to a reduction of costs as compared to the traditional view ?

[For the new theory of OCA, countries need not fulfil any criterion before joining (neoclassical assumption): upon joining, there will be convergence. You do not need to do anything because convergence becomes endogenous.] *A. The vertical Phillips curve and monetary policy ineffectiveness* Earlier view on monetary policy: a point on the Phillips curve can be chosen: "surprise inflation can buy lower unemployment". [No trade-off between inflation and unemployment: prices are fully flexible, so wages are too] But: • Observation of rising unemployment and rising inflation in the 1970s and the early 1980s (stagflation): Phillips curve assumption does not hold • Friedman-Phelps argument on the vertical long-run Phillips curve: the inflation-expectations augmented Phillips curve • Lucas: perfectly anticipated short-term changes will have no impact on real variables These new theoretical insights suggest that monetary policy has no real effects such that the cost of losing the monetary policy instrument is smaller than what was previously expected. [New theory of OCA assumes that money is neutral. So monetary policy has nothing to do with convergence. Fiscal policy is ineffective too: Ricardian equivalence: timing of taxes does not affect consumption. Just make a union and convergence will come endogenously.] *B. Exchange rate hysteresis* When a firm that considers to start exporting faces high entry costs on that market (these moreover are sunk costs, cf. advertising, the costs of setting up local sales agencies, etc), exchange rate movements may fail to generate strong effects on behaviour of firms. High entry costs then cause hysteresis (inertia in moving away from the present situation): a small change in the exchange rate will be unlikely to incite many firms to leave or enter the market. [Example of what led to the development of the new theory of OCA. That is, ER movements or costs related to opening up new firms will lead to frictions which might incite divergence across economies. Example of what the proponents believe about the reasons behind asymmetries across countries. Supply-side of the economy.] *C. Exchange rates and Ricardian equivalence* For instance, expansionary fiscal policy through a reduction in taxes should lead to an appreciation of the exchange rate. Indeed: reduction in taxes -> consumption rises -> income rises -> domestic money demand rises -> domestic money becomes scarcer when compared with foreign money such that its price, i.e. the exchange rate, appreciates. [This is what happens in reality. But according to the new theory this channel does not exist, because Ricardian equivalence holds. What triggers an ER appreciation (expansionary fiscal policy) does not hold.] Ricardian equivalence may break this chain of effects. If private agents expect future tax increases in order to pay for the present tax reduction, they may decide to increase savings rather than to increase consumption. The above exchange rate appreciation then also will not materialise. If Ricardian equivalence applies, the exchange rate will react less to fiscal policy measures and the value of the fiscal policy instrument is limited such that the cost of seeing the fiscal policy instrument being severely limited in a currency area is smaller than was previously expected. [ER reacts very little to changes in fiscal policy, if at all, in the case of Ricardian equivalence.]

What did the PBC do in the face of strong international pressure for appreciation in 2010 ?

• 19 June 2010: - In the midst of strong international pressure for an appreciation of the Renminbi (RMB), China announced a "new direction" in its exchange rate regime [Financial crises affect ER regimes accordingly. This is one of the risks the PBC was running into: in the middle of the crisis, the major currencies (the euro, the dollar, the yen, etc) were collapsing, implying that, as the PBS was holding so much of those assets, their value was going down for the Bank. So it could increase the supply of its currency to a smaller extent, so that its ability to defend its ER regime was going down. This did not hurt the credibility of the peg itself too much, as it was still holding a large amount of those foreign reserves. But still, its ability to defend goes down, because the value of those assets goes down, and the value of those assets has to be aligned with how much you increase domestic currency in circulation. Holding dollars which amount to 3 euros, if the value of these dollars goes down to 2 euros, then you will also have to increase your money supply by 2 euros, not by 3 as you would usually. The PBS wants these foreign reserves to hold as much value as possible in order to be more powerful when defending its peg. These currencies losing value means the PBC is less powerful, and thus to solve this it has to align its currency a bit more on that of the major countries. ] - On 19 June 2010, the Chinese central bank (People's Bank of China, PBC) announced the following: "It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility. ... The People's Bank of China will ... maintain the RMB exchange rate basically stable at an adaptive and equilibrium level ..." [The Bank showed more tolerance to ER fluctuations. It did not fluctuate freely but in wider margins. Completely sterilised interventions are consistent with fixed peg. China is not fixing its ER, but a managed float. ] • 21 June 2010 - 11 November 2011 - the Renminbi was allowed to appreciate by about 6.7% Thus: since 20 July 2005, the Renminbi was allowed to appreciate by about 23.4% [All these facts reveal that there are pressures to the Chinese currency to appreciate. This is related to the belief that Chinese products are cheaper simply because of the fact that the currency is undervalued vis a vis the basket of currencies against which the Chinese authorities are pegging the RMB. ]

When and how did the RMB get fixed to the dollar ? Which ER regime was adopted effectively ?

• 1994: unification of the Renminbi exchange rates at the then prevailing US dollar rate that was also chosen as the peg which fixed the Renminbi to the US dollar at 8.28 Renminbi per US dollar • Gradual narrowing of fluctuation margins to ±0.1%: crawling peg around 8.28 value [ Favours Chinese exports]

When did the RMB change value against the dollar ? Did it appreciate or depreciate ? What was the Chinese CB's policy ? How can you defend your currency within such a system ? What is special about the Chinese managed ER regime ? Why did the Chinese increase their floating band in 2007 ?

• 21 July 2005: - Revaluation of the Renminbi by 2.1%: let the RMB appreciate against the dollar - Official terminology: "Adoption of a managed float around a basket of the currencies of the main trading partners with a maximum shift of the target rate by 0.3% per day". The currencies in the basket and the weights were never officially disclosed. [ Let the currency appreciate following world market pressures.] [How can you defend the currency ? Not only interest rates but also manipulation of foreign reserves. When a CB pegs or control value of currency, important that bank accumulates enough foreign reserves (open market operations), to defend the currency whenever there is an attack. Whenever the credibility of the ER regime drops, then currency might be subject to attacks. Credibility collapses when foreign reserves are no longer enough. Currency attacks depreciate value of currency. Against such attacks, CB accumulate foreign reserves, withdraw domestic currency and supply foreign reserves on the market to appreciate the currency. China is a special case because not only it is the most common fixed ER regime in the world (managed float), but also because the currency is subject to appreciating pressures (and not depreciating as is the case usually). This is because the managed ER regime of China does not rely on the value of the currency that is related to capital markets but instead to goods market. That is why they want to sustain a lower value of the currency in order to be more competitive, as opposed to other ER regimes that want to fix the value of the currency simply because they have foreign currency-denominated debt and they want to secure a fixed value for their international obligations.] - On 19 May 2007, the Renminbi band was increased from 0.3% to 0.5% (surprisingly only towards the US dollar) [Either because of international pressures, to put a brake on accumulation of foreign reserves or because they want to pursue other kinds of policies (because of incompatible trinity problem).]

How is the RMB ER determined in practice ?

• Every morning, the PBC announces the central parity rate for that day and deals within a range of ±0.5% around that rate • Exporters, etc essentially supply large-enough quantities of US dollar on a daily basis that would drive up the value of the RMB far faster than the PBC desires • This means that the central parity (and its growth rate) can only be obtained by the PBC through buying those US dollar in exchange for RMB [Chinese and international goods market react and start invoicing their goods accordingly. This means that the central parity can only be obtained by the PBC through buying those US dollars in exchange for RMB. There are appreciating pressures to the currency, and the PBC does market operations where it buys foreign reserves and increases the supply of domestic currency. ]

What did the Chinese CB do in the face of the crisis in order not to hurt exports ?

• June 2008 - 18 June 2010: - The managed float system officially remained in place but the exchange rate of the Renminbi versus the US dollar grew completely fixed again (as a ''special measure") - This step was taken in order to not jeopardize exports via appreciations in the midst of a global economic crisis in which exports were on the decrease already (e.g. Chinese overall exports decreased by 16% between 2008 and 2009). [Appreciating pressures to the RMB simply because the other major currencies, including the US dollar, were depreciating. This was a pressure effectively put on Chinese exporters.]

What are the consequences this ER determination ?

• Two consequences arise: - A near-to-continuous increase in the foreign- exchange reserves held by the PBC [Typical for currencies with appreciating pressures] - A near-to-continuous increase in the supply of RMB. Indeed, only 50%-70% of the abovementioned interventions are sterilised [Continuous increase in money supply, so you have a pressure to lower interest rates, and part of this effect has to be undone by allowing the demand for money to increase or to cut money supply back by using this money to finance government debt.