International Economics

Economic Integration,
Optimum Currency Areas
and the Euro
a.y. 2022/2023

Tamar Taralashvili
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 Economic Integration
Economic integration describes the process
whereby countries coordinate and link their
economic policies
• As the degree of economic integration increases
– the trade barriers between countries decrease
– fiscal and monetary policies are more closely
linked
– until they are one

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 Economic Integration: Key Terms
1) Bilateral trade agreement
– Definition: an agreement relating to trade between
two countries
– The aim is usually to reduce or remove tariffs and/or
quotas that have been placed on items traded
between the two countries
2) Multilateral trade agreement
– Definition: an agreement relating to trade between
multiple countries
– Aims to reduce or remove tariffs and/or quotas that
have been placed untraded items, but the agreement
applies to all of the countries involved 3
 Economic Integration: Key Terms
3) Trading blocs
– Definition: a group of countries that join together in
some form of agreement in order to increase trade
between themselves and/or to gain economic benefits
from cooperation on some level
– This coming together is economic integration

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 Six Stages of Integration
1) Preferential trading areas (PTA)
– Definition: a PTA is a trading bloc that gives
preferential access to certain products from certain
countries
– This is usually carried out by reducing, but not
eliminating tariffs
– An example of a PTA is the one between the EU and
the African, Caribbean, and Pacific (the ACP) group
states

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 Six Stages of Integration
2) Free trade areas
– Definition: a free-trade area is
an agreement made between
countries, where the countries
agreed to trade freely among
themselves but are able to
trade with other countries
outside of the free-trade area
in whatever way they wish Source: Jocelyn Blink

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 Six Stages of Integration
3) Customs unions
– Definition: a customs union is
an agreement made between
countries, where the countries
agreed to trade freely among
themselves, and they also
agreed to adopt common
external barriers against any
country attempting to import
into the customs union
– The European Union is a Source: Jocelyn Blink

customs union

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 Six Stages of Integration
4) Common markets
• Definition: a common market is a customs union with
common policies on product regulation, and free
movement of goods, services, capital, and labor.
• The European Union is a common market

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 Six Stages of Integration
5) Economic and monetary union (EMU)
– Definition: an economic and monetary union is a
common market with a common currency and a
common central-bank
– The best example of economic and monetary union is
the Eurozone, which includes the member countries
of the European Union that have adopted the euro as
their currency and have the European Central Bank
(ECB) as their central bank

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 Six Stages of Integration
6) Complete economic integration
– Definition: this is the final stage of economic
integration at which point the individual countries
involved would have no control of economic policy,
full monetary union, and complete harmonization of
fiscal policy
– This is what the eurozone is moving towards

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Levels of Economic Integration

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Advantages and Disadvantages
Advantages
– The extent of the advantages and disadvantages of
trading blocs clearly depends on the degree of
integration
– Similar to those of free-trade arguments
– Larger market size
– Increased foreign investment
– A trading bloc will foster greater political stability and
cooperation
– Trade negotiations will be easier as there will be
larger blocs of countries
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Advantages and Disadvantages
Disadvantages
– Trading blocs favor increased trade among members,
but act as a discriminatory policies against non-
members
– They may undermine the international trade rules and
limit the potential gains of trade achievable with freer
forms of world trade
– More of a problem for small or poor economies that
have little bargaining power

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 United Europe
• Philosophers of the 17th and 18th centuries
• 1923 - Pan European Movement
• 1927 - European Federation
• 1930 - United States of Europe
• 1941 - Ventotene Manifesto

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 What is the European Union?
- 1945 devastated Europe, the US and USSR are major powers
- 1947 Marshal Plan
- 1950 Robert Schuman
- 1951 ECSC – Belgium, the Netherlands,
Luxembourg, Italy, France, west Germany
- 1957 EEC and Euratom
- 1973 UK, Ireland, Denmark
- 1981 Greece
- 1986 Spain, Portugal and
Single European Act
- 1993 the European Union
- 1997 Schengen-the treaty of Amsterdam
- 2002 Euro in circulation
- 2004 largest extension
- 2007 Romania, Bulgaria and Lisbon Treaty
- 2013 Croatia
- 2020 UK exit 15
 What is the European Union?
The European Union is a system of international
institutions, the first of which originated in 1957,
which now represents 27 European countries
through the following bodies:
– European Parliament: elected by citizens of member
countries
– Council of the European Union: appointed by
governments of the member countries
– European Commission: executive body
– Court of Justice: interprets EU law
– European Central Bank, which conducts monetary
policy through a system of member country banks
called the European System of Central Banks 16
 What Is Euro?
No Euro
Denmark
Sweden
Czech Rep.
Hungary
Poland
Bulgaria
Croatia
Romania

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 History of Euro and EMS
• Treaty of Rome (1957) outlined measures to
promote coordination in economic and monetary
matters
• Bretton Woods System
– based on fixed exchange rates between the US
dollar and Western currencies
– the dollar is tied to gold and the other currencies
are tied to the dollar
• 1969 – Hague Summit – relaunch of the
European monetary integration process
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 History of Euro and EMS
• 1971 – end of the Bretton Woods System
• 1972 – creation of the ‘Currency Snake’
– currencies to fluctuate ±2.25% around target
exchange rate
• 1973 – oil crisis and failure of the currency
snake
• 1978 – proposal to create European Monetary
System (EMS)

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 European Monetary System
Key elements:
• Virtual ’European Currency Unit’ (ECU)
• Exchange Rate Mechanism (ERM)
– Currency can fluctuate by ±2.25% around the
central rate

The European Monetary System was originally

a system of fixed exchange rates implemented
in 1979 through an exchange rate mechanism
(ERM)
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 European Monetary System
• From 1979 to 1993, the EMS defined the ERM
to allow most currencies to fluctuate ±2.25%
around target exchange rate
• The ERM allowed larger fluctuations ±6% for
currencies of Portugal, Spain, Britain and Italy
– These countries wanted greater flexibility with
monetary policy

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 European Monetary System
• To prevent large fluctuation
– Some exchange controls were also enforced to limit
trading of currencies
– A common market for financial assets
• A credit system was also developed
• Differences in monetary and fiscal policies
across the EMS
• In 1986 the European Community adopts the
project of Single European Act with an objective:
– Monetary union
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– Single currency
 Economic and Monetary Union in
Three Stages
Stage 1:
• Closer coordination of economic and monetary policies
• Free movement of capital
Stage 2:
• Monetary policy gradually transferred to EC institutions
• European System of Central Banks (ESCB)
• Narrower fluctuation bands
Stage 3:
• Monetary competence transferred to EC
• Fixed exchange rates
• European currency 23
 Economic and Monetary Union
• 1990 - start of stage 1
• 1992 - Maastricht Treaty
– Transform EEC into Economic and Monetary Union
– Single currency by 1999
– Convergence criteria: exchange rate stability; limits to
public deficit and debt; durable convergence; price
stability
• From 1993, currencies were allowed to fluctuate
±15% around central exchange rate
• UK and Denmark opt-out from the monetary
union 24
 Economic and Monetary Union
• 1994 - start of stage 2
– Creation of the European Monetary Institute
• 1998 - 11 countries are in Monetary Union
• 1999 - start of stage 3
– Euro is introduced
• 2002 - Euros start to circulate

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 From EMS to Economic and
Monetary Union
The EMS has developed into an economic and
monetary union (EMU), a more extensive system
of coordinated economic and monetary policies
– The EMS has replaced the exchange rate mechanism
for most members with a common currency under the
economic and monetary union

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 Why the EU and EMU?
Countries that established the EU and EMU had
several goals
– To enhance Europe's power in international affairs: as
a union of countries, the EU could represent more
economic and political power in the world
– To make Europe a unified market: a large market with
free trade, free flows of financial assets, and free
migration of people - in addition to fixed exchange
rates or a common currency - was believed to foster
economic growth and economic well-being
– To make Europe politically stable and peaceful
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Theory of Optimum Currency Areas
The theory of optimum currency areas argues
that the optimal area for a system of fixed
exchange rates, or a common currency, is one
that is highly economically integrated
• Economic integration means free flows of
– Goods and services (trade)
– Financial capital (assets) and physical capital
– Workers/labor (immigration and emigration)

The theory was developed by Robert Mundell in 1961

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 Benefits of Joining a Fixed
Exchange Rate System
• Avoid the uncertainty and international
transaction costs that floating exchange rates
involve
• The gain that would occur if a country joined
a fixed exchange rate system is called the
monetary efficiency gain

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 Benefits of Joining a Fixed
Exchange Rate System
Beneficial if:
• Trade is extensive between it and member
countries because transaction costs would be
greatly reduced
• Financial assets flow freely between it and
member countries, because the uncertainty
about rates of return would be greatly reduced
• People migrate freely between it and member
countries, because the uncertainty about the
purchasing power of wages would be greatly
reduced 30
The GG Schedule

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Costs of Joining a Fixed Exchange
Rate System
• Costs of fixed exchange rates are that they
require the loss of monetary policy for stabilizing
output and employment, and the loss of
automatic adjustment of exchange rates to
changes in aggregate demand
• We define this loss that would occur if a country
joined a fixed exchange rate system as the
economic stability loss

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Costs of Joining a Fixed Exchange
Rate System
• After joining a fixed exchange rate system, if the
new member faces a fall in aggregate demand:
– Relative prices will tend to fall, which will lead other
members to increase aggregate demand greatly if
economic integration is extensive, so that the
economic loss is not as great
– Financial assets or labor will migrate to areas with
higher returns or wages if economic integration is
extensive, so that the economic loss is not as great
– The loss of the automatic adjustment of flexible
exchange rates is not as great if goods and services
markets are integrated
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Costs of Joining a Fixed Exchange
Rate System
Why?
• Consider what would have happened if the
country did not join the fixed exchange rate
system:
– The automatic adjustment would have caused a
depreciation of the domestic currency and an
appreciation of foreign currencies, which would have
caused an increase in many prices for domestic
consumers when goods and services markets are
integrated

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The LL Schedule

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Deciding When to Fix
the Exchange Rate

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 Change in Aggregate Demand
• If aggregate demand changes the economic
stability loss would be greater for every measure
of economic integration between a new member
and members of the fixed exchange rate system
• How would this affect the critical point where the
monetary efficiency gain equals economic
stability loss?

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An Increase in Output Market
Variability

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 Is the EU an Optimum Currency Area?

If the EU/EMS/economic and monetary union can

be expected to benefit members, we expect that its
members have a high degree of economic
integration:
– Large trade volumes as a fraction of GDP
– A large amount of foreign financial investment
and foreign direct investment relative to total
investment
– A large amount of migration across borders as a
fraction of total labor force
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 Evidence on the EU’s Optimum
Currency Area
• Regional migration is not extensive in the EU
• Europe has many languages and cultures, which
hinder migration and labor mobility
• Unions and regulations also impede labor
movements between industries and countries
• Differences of U.S. unemployment rates across
regions are smaller and less persistent than
differences of national unemployment rates in
the EU, indicating a lack of EU labor mobility

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 Evidence on the EU’s Optimum
Currency Area
• Deviations from the law of one price also occur
in many EU markets
– If EU markets were greatly integrated, then the
(currency adjusted) prices of goods and services
should be nearly the same across markets
– The price of the same BMW car varies 29.5%
between British and Dutch markets

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 The Future of EMU
• Europe is not an optimum currency area.
Therefore, asymmetric economic developments
within different countries of the euro zone
developments that might well call for different
national interest rates under a regime of
individual national currencies - will remain hard
to handle through monetary policy

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 The Future of EMU
• In most EU countries, labor markets remain
highly unionized and subject to employment
taxes and regulations that impede labor mobility
between industries and regions. The result has
been persistently high levels of unemployment.
Unless labor markets become much more
flexible, individual euro zone countries will have
a hard time adjusting toward full employment
and competitive real exchange rates

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 Summary
• Economic integration describes the process
whereby countries coordinate and link their
economic policies
• As the degree of economic integration increases
– The trade barriers between countries decrease
– Fiscal and monetary policies are more
– closely linked
– Until they are one
• Six stages of integration
– PTAs; Free trade areas; Customs unions; Common
markets; EMU; Complete economic integration 44
 Summary
• The EMS was first a system of fixed exchange
rates but later developed into a more extensive
coordination of economic and monetary policies:
an economic and monetary union
• The Single European Act of 1986 recommended
that EU members remove barriers to trade,
capital flows, and immigration by the end of
1992

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 Summary
• The Maastricht Treaty outlined 3 requirements
for the EMS to become an economic and
monetary union
– It also standardized many regulations and gave the
EU institution more control over defence policies
– It also set up penalties for spendthrift EMU members
• A new exchange rate mechanism was defined in
1999 vis-a-vis the euro, when the euro came
into existence International

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 Summary
• An optimum currency area is a union of
countries with a high degree of economic
integration among goods and services, financial
assets, and labor markets
– It is an area where the monetary efficiency gain of
joining a fixed exchange rate system is at least as
large as the economic stability loss
• The EU does not have a large degree of labor
mobility due to differences in culture and due to
unionization and regulation
• The EU is not an optimum currency area 47
 Reading
Chapter 21

P. KRUGMAN-M. OBSTFELD-M. MELITZ,

International Economics: Theory and Policy, Eleventh
Edition, Pearson, 2018

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