«Russia and the World Community’s Respond to a Challenge of Instability of Economic and Legal Systems Materials of the International Scientific-practical Conference ...»
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The Relevance of Economic Theory for European Integration Introduction European integration is now at the edge, when the euro area is characterized by signs of a very delicate project. Economic and monetary union (EMU) is regarded as an unprecedented experiment. Two approaches has shaped at its inception in professional circles. The first considers the EMU as logical strengthening of economic and monetary ties within the EU to strengthen economic, social and political cohesion. The second approach considers monetary union as a result of political decisions without considering the economic consequences of introducing a single currency and without a coherent strategy leading to political unification.
More than a decade of the EMU existence is accompanied by controversial assessments. The relative consensus exists in defining the main benefits of the single currency. It is increased competitiveness and transparency, reduced exchange rate fluctuations and elimination of uncertainty in the euro area and inA paper was elaborated in the framework of the project OPVaV titled „Creation of Excellent Economic Research s Workplace for Research of civilization challenges in 21st century (ITMS 26240120032). We support the research activity in Slovakia/ Project is co-financed by the EU. Prspevok vznikol v rmci rieenho projektu OP VaV s nzvom Vytvorenie excelentnho pracoviska ekonomickho vskumu pre rieenie civilizanch vziev v 21. storo (ITMS 26240120032). Podporujeme vskumn aktivity na Slovensku/Projekt je spolufinancovan zo zdrojov E.
creased price stability. But the question is what are the costs of this monetary arrangement in Europe.
The theoretical basis for analyzing the advantages of membership in a monetary union represents the theory of optimum currency area. This theory has been described as wondrous doctrine which can often be the background for quite contradictory conclusions. Defenders of the common currency and critics as well refer to this theory. Theory of optimum currency areas allow to answer the questions: what are the conditions for the participation in the monetary integration, and then, what are the costs and benefits of joining to monetary union.
The paper deals with the theoretical approaches to the current degree of European integration i.e. monetary union.
1. Exchange Rate Arrangements and Economic Performance There is extensive literature devoted to issues of relation between systems of exchange rates and economic growth. Economists arguing in favor of fixed exchange rates say that the stable exchange rate generates macroeconomic stability and thus accelerates economic growth. This is particularly true for small open economies. McKinnon and Schnabl (2004) argue that exchange rate stability contributes to low inflation and good conditions of public finance and stable expectations generate investments and long-term growth in regions. The literature also notes contrary views – adjustment of real exchange rates in a system of fixed exchange rates takes place explicitly through changes in relative prices, which is costly and time consuming in terms of price rigidity.
A discussion whether the exchange rate stability leads to higher or lower economic growth is essentially an empirical question. It is not surprising that empirical studies lead to different conclusions. De Grauwe and Schnabl (2008) present the results of a study of various authors: Mundell (1995) finds faster growth in GDP during the period of monetary stability, Baillie et al. (2003) consider temporary monetary regime and a floating currency regime as negatively contributing factors to economic growth, another study shows a weak correlation between exchange rate regime and growth (Gosh et al. 2003), according to Edwards and Levy-Yeyatiho (2003) countries with flexible exchange rates are growing faster, Eichengreen, Leblang (2003) found a strong negative relationship between exchange rate stability and economic growth, which examined data of 12 countries over a period of 120 years. De Grauwe, Schnabl investigated the effect of exchange rate regime on the rate of economic growth in the countries of Southeastern and Central Europe during the pre-accession period to the EU. They found that the fixed linking currencies of these countries to the euro had benefits in terms of greater trade (similar results found Frankel and Rose, 2001) and also lower interest rates. Stable exchange rate meant for those countries creation of stable macroeconomic environment.
Consideration of whether the euro together with the independent ECB is good or bad idea can be evaluated only in the meaning of performance of the economy – whether the euro contributes to a rapid growth in the euro area. Economic growth in the euro area has been at minimum rate after the euro introduction. It was assumed that the euro will stimulate economic growth by reducing interest rates and stimulating investment. This phenomenon, however, occurred only in some countries, not Europe as a whole. So there are legitimate questions of Great Britain and Sweden if joining the euro area provides higher growth.
Rather, there is a belief to the contrary, namely that the euro will contribute to slower growth and higher unemployment (Stiglitz, 2003).
Since the introduction of common currency economic growth in the euro area has been actually low in comparison to the situation in the U.S. and European countries outside the EMU. The causes of slow economic growth performance of the euro area are different i.e. structural and other economic differences among countries joined in the monetary union, complicated implementation of the single monetary policy, lack of labour market flexibility, asymmetry that makes difficult to keep effective coordination of monetary and fiscal or structural policy, high taxes, lack of fiscal solidarity, substantial differences in tax systems of member states, excessive regulation of business activity, excessive bureaucratisation of decision-making in the EU and the threat of negative asymmetric shocks.
2. The Theory of Optimum Currency Area R.A. Mundell is the most important economist dealing with OCA. According to Mundells original theory, the optimal currency area is an area where there is high mobility of factors. Mundell defines optimality as the ability to stabilize employment and price levels in the country. In other words, if the economy manages to maintain external balance without an increase in unemployment or without an increase in inflation induced demand, the existing exchange rate regime (whether it is a floating or fixed) is considered as optimal.
Based on the previous analysis Mundell concludes: if there is sufficient mobility of production factors within the country but low in relation to foreign countries, the national currencies, should operate effectively under floating exchange rates (Mundell, 1961, p. 664). In 1973 R. Mundell developed his original theory and analyzed the free movement of capital. The exchange rate stopped to be an effective instrument of monetary policy to stabilize the economy and on the contrary it has become a potential source of asymmetric shocks. The countries that did not enter into monetary union, may become targets of destabilizing capital flows and will face asymmetric shocks. Therefore the exchange rate may not be effective to eliminate the effects of such shocks. This theory is known as the Mundell II. Membership in EMU helps to insure against this type of asymmetric shocks. The originality of Mundell’s approach in formulating the problem influenced the work of further generations of economists, who consider the two case studies contained in his work (monetary union and a floating exchange rate regime) as the most important alternatives.
R. I. McKinnon (1963) 184 proposed openness as a criterion of optimum currency area. Membership in a monetary union brings benefits from the integration MC KINNON, R. J.: Optimum Currency Areas. American Economic Rewiev, 53, 1963.
of the country, higher openness leads to higher savings in transaction costs and greater benefits from the elimination of exchange rate volatility. Openness of the eurozones countries is relatively high.
In 1969 P. B. Kenen 185 suggests the degree of product diversification as a criterion for determining the fixed exchange rates. If the country produces and exports a diversified range of products, the negative impact of asymmetric shocks is smaller than in less diversified economy. In this case, it is not necessary to change in the exchange rate. The fixed exchange rates become more favorable if the product diversification increases. Countries that specialize in one sector are more vulnerable in case of asymmetric shocks. In the case of a demand shock an independent monetary policy would be an effective tool for solving problems in these countries.
J. M. Fleming (1971) pointed out that only countries with almost the same rate of inflation may enter and remain fixed exchange rates. Different rates of inflation are the main cause of current account imbalances. The same rate of inflation between countries enables the maintenance of relative purchasing power parity and, consequently, leads to the stabilization of business conditions. In the long run the stable foreign trade relations lead to current account balance and the need to use the exchange rate change is minimized. If inflation diverges too much a system of fixed exchange rates between countries can not be maintained in the long-term. It means that a monetary union must undergo the steps towards convergence of inflation rates.
The other criteria were proposed as follows: fiscal solidarity and homogeneity of preferences. Homogeneity of preferences means that there is a consensus accross monetary zone on the way how to react in case of negative developments. Fiscal solidarity may occur in the form of fiscal transfers. Summary of the criteria of optimum currency areas provide a study developed by Tavlas (1993) and Mongelli (2002).
Optimum currency area criteria was based on economic evaluation of costs and benefits, countries may decide to join a monetary union on the basis of political reasons, since the common currency may be a first step towards the creation of political union. OCA are not black and white issue. Some may be partially met and others not at all (Baldwin, Wyplosz, 2008).
3. Joining monetary union – arguments for and against Mundell’s theory of the optimal currency area was to become the starting point of controversies over the establishment of EMU. In his latest works Mundell has again returned to a cost-benefit analysis of monetary union attempting a systematic definition of the arguments for and against joining a currency area.
According to Mundell (1997), a country should consider membership of a currency union, or zone with fixed exchange rates for these reasons: if the country has an interest to maintain a rate of inflation different from the rate of inflaKENNEN, P. B.: The Theory of Optimum Currency Areas:An Eclectic View, In: R. Mundell, A. Swoboda:
Monetary Problems of the International Economics. University of Chicago Press 1969.