Real Exchange Rates, Structural Reforms and Monetary Union

Hefeker, Carsten Article Real Exchange Rates, Structural Reforms and Monetary Union Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Hefeker, Carsten (2009) : Real Exchange Rates, Structural Reforms and Monetary Union, Kredit und Kapital, ISSN 1865-5734, Duncker & Humblot, Berlin, Vol. 42, Iss. 2, pp. 195-212, https://doi.org/10.3790/kuk.42.2.195 This Version is available at: https://hdl.handle.net/10419/293609 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Real Exchange Rates, Structural Reforms and Monetary Union By Carsten Hefeker, Siegen* I. Introduction After European Monetary Union (EMU) has successfully started, the next major task is its enlargement. The question is whether all of the countries that joined the European Union (EU) in May 2004 and January 2007 are sufficiently close in economic structure to join monetary union as well (Ca’Zorzi/De Santis (2005); Ca’Zorzi et al. (2005); Eickmeier/ Breitung (2006); Fidrmuc/Korhonen (2003, 2006)), and whether they should join immediately or later (Buiter (2004); Maurel (2004); De Grauwe/Schnabl (2006)). And what impact would it have if countries joined before convergence? In the view of the European Central Bank (ECB (2004)) not only inflation and fiscal policy should be sufficiently converged before enlargement is possible without posing macroeconomic dangers to current and new members. Most of the literature on monetary unification stresses the importance of similarity of economic structures for the success of a monetary union (Bayoumi/Eichengreen (1996)). This literature usually takes the economic structure of countries as given, without realizing that economic structures change over time (see, however, De Grauwe/Mongelli (2005)). The question when a candidate country might be sufficiently reformed to join an existing monetary union has been formally addressed by Martin (1995) who, however, takes the convergence of an economy with high distortions as given. Endogenous structural reform, in turn, have been analyzed by Ozkan et al. (2004) and Beetsma/Jensen (2003), where the candidate country must decide how much to reform. In Beetsma/Jensen (2003) candidates always want to join, whereas in Ozkan et al. (2004) they decide whether they wish to fulfill entry criteria. Kredit und Kapital, 42. Jahrgang, Heft 2, Seiten 195–212 Abhandlungen * I am grateful to an anonymous referee for helpful comments. Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 However, present members of the monetary union also need to implement structural adjustments and the question is whether these reforms are speeded up or slowed down by enlargement (see Hughes Hallett/Jensen (2003)). Assuming that structural reforms and monetary expansion are perceived by governments as strategic substitutes to increase employment, Calmfors (2001), Sibert (1999) and Sibert/Sutherland (2000) have argued that labor market reforms will be lower in a monetary union. Since inflationary pressure due to labor market problems is automatically reduced in a monetary union, incentives for governments to implement structural reforms fall. While Duval/Elmeskov (2005) find some support for this prediction, broader samples of countries can not confirm this relation between monetary regime and structural reforms (Belke et al. (2007)). Consistent with the mixed evidence, I show that the theoretical result need not hold in general. By introducing asymmetries in the degree of distortions and reform needs, I show that monetary union with a high distortion country can actually increase the incentives to implement reforms and lead to more reforms in low distortion countries. In other countries, in contrast, reform efforts could fall. Whether this is the case depends on the relative amount of distortions in the two countries, the presence and size of structural inflation differences, and countries’ openness. Thus, earlier literature might paint too simple a picture and asymmetries, which are arguable more relevant for a larger monetary union, might yield additional effects. Also, I show that a “hard” currency peg, such as a currency board or a unilateral adoption of an anchor currency is not enough to induce structural reforms in the pegging country. Finally, I show that by taking into account the real exchange rate results may be further qualified in comparison to what earlier literature has derived. Taking into account that a monetary union need not imply constant real exchange rates as inflation rates differ, for instance because of the Balassa-Samuelson effect, incentives to implement reforms are additionally affected. I show that a real appreciation, because it affects their international competitiveness, increases countries’ incentives to implement structural reforms. The paper is structured as follows: The next section discusses briefly the different dimensions of structural reforms that present and future member states of the monetary union exhibit. The following section sets up the basic model and derives monetary policy decisions in each country. Section IV determines the amount of structural reforms in the two 196 Carsten Hefeker Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 countries and section V considers the alternative of a one sided hard peg. Section VI concludes. II. The Need for Structural Reform Compared with the situation from which they started, most of the accession countries have made considerable progress. 1 However, in many respects they are still quite a distance away from the European average; most clearly with respect to inflation and budget deficits (Lane (2006); EBRD (2007)). Moreover, while growth of productivity and GDP are higher than in older EU member states, higher unemployment and larger shares of agriculture and industry in GDP point to the still ongoing process of structural adjustment, which is also evident from a relatively large public sector. In particular, the large share of agriculture in some economies implies large fiscal requirements to subsidize and phase out this sector over time, and large current account deficits and external debt suggest that some of the countries are vulnerable to current account and currency crises. All this could pose danger for monetary policy. Another important influence on monetary policy is the structurally higher rate of inflation in the accession countries (Ca’Zorzi/De Santis (2004); MacDonald/Wojcik (2005)). According to the Balassa-Samuelson theory, higher productivity increases in the tradables sector lead to strong wage increases in the tradables sector that spill over into the nontradables sector, pushing up the relative price of non-tradable goods. This leads to a trend appreciation in the real exchange rate, making it difficult to fix the nominal exchange rates. Inflation differentials between accession countries and EMU members would then require either a very tight monetary policy in the accession countries or floating exchange rates (see e.g. Buiter/Grafe (2002)). Estimates of the size of this effect, however, differ widely. While Corker et al. (2003) and Mihaljek/ Klau (2003) argue that up to 2 percent of the inflation differential between accession countries and EMU average is due to this effect, Ègert/ Halpern (2006), Égert et al. (2006), and Garcia-Solanes et al. (2007) find that most of the inflation increase in accession countries cannot be attributed to the Balassa-Samuelson effect. Last not least, new member states are usually doing worse when compared to older member states with respect to their institutional quality. Real Exchange Rates, Structural Reforms and Monetary Union 197 1Continuous monitoring is provided by the EBRD’s Transition Report and the EU Commission’s Convergence Report. Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 Using the usual indicators, such as the Freedom House index on government size, freedom to trade and labor and product market regulation, or the World Bank index (Kaufman et al. (2007)) on political stability, rule of law, absence of corruption and government efficiency, shows they are often behind particularly with respect to institutional quality. 2 On the other hand, Boeri/Garibaldi (2007) find that in terms of labor market regulation, new members are usually showing more flexibility and adaptability in terms of employment protection laws or unemployment benefits. In general, labor market regulation is less restrictive and unions have a lower influence on labor markets. They also find that wages are more in line with productivity developments than in older member states and attribute the higher unemployment in these countries mainly to fiscal policy rather than labor market policies. Weighing different dimensions of labor market regulation and other institutions thus provides no clear evidence on which group of countries (let alone single countries) are more distorted, and there is considerable evidence that the current members as well have a need for structural reforms in some areas, particularly in labor and product markets. The theoretical analysis will thus abstract from any particular type of regulation and simply acknowledge that countries are different and more or less in need of reforms, depending on the particular type of regulation and distortions that is looked at. This observation is the starting point for the following theoretical analysis. III. Monetary Policy with and without Monetary Union 1. The Basic Model Consider two countries, one in which the level of structural distortions is relatively high, labeled H, while the other, labeled L, is characterized by lower structural distortions. This should capture the presence of asymmetries between the existing monetary union and the candidates for enlargement. As argued above, depending on the particular form of distortion, candidates for EMU might be more or less distorted than current members. Each country’s government determines the amount of structural reforms in each period while the central bank sets monetary policy. Both 198 Carsten Hefeker 2This is particularly true for the next wave of member states, as Hammermann/ Schweikert (2005) report. Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 interact with a private sector that rationally forms expectations about the rate of inflation, and both are interested in achieving full potential output and avoiding inflation. The government is additionally reluctant to implement structural reforms since this risks hurting voters and interest groups (Saint-Paul (2000)). Labor market reforms as well as structural reforms more generally are usually not happily accepted by the population, and the improvement of institutional quality might be opposed by those who presently benefit from distortions such as corruption and red tape because they create rents (Huang/Wei (2006)). I express inflation in both regions ÈiãL;Hêin the form of a simple quantity equation (with constant velocity, normalized to zero here) pi tãmi tyi t;È1ê where mi trefers to the rate of money growth set by the central bank (the policy instrument) and yi trefers to the output level. Equilibrium requires that money demand equal money growth. For simplicity, the (log of) potential output is normalized to zero and actual output is increasing in the difference between the average price level and the average wage level pi twi t. Wages in country i are given as wi tã^ wwi tþEpi t with Ebeing the expectations operator. That is, wages are increasing in the expected rate of inflation and also in a component reflecting a target level of real wage increase. If average wages are increasing faster than productivity and expected inflation in a country this has negative influence on output. This should reflect the negative effect on average output in a country if average wages are increasing faster than average productivity. 3 As argued above, factors that further reduce output can be a distorting tax system, a deficient legal system (the absence of rule of law), corruption or excessive regulation of product markets or investments. Collecting such factors, which are usually comprised in ease of doing business and institutional quality indicators, as xi, total distortions can be summed as ki tãxiþ^ wwi t. They can be reduced through structural reforms si t, which can be understood as the reform efforts of a country in terms of Real Exchange Rates, Structural Reforms and Monetary Union 199 3The rate of inflation could also be expressed as a weighted average of price increases in the tradable (T) and non-tradable (NT) sector pi tãxpT;i tþ1xÈêpNT;i t, with a similar expression for wages (see, e.g. Buiter/Grafe (2002)). For simplicity, I look only at averages in what follows. Likewise, one could correct real wage increases for productivity increases and focus on the difference. I normalize productivity growth to zero here. Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 improving institutional quality or reducing regulation in labor and product markets. 4 Since distortions are not specifically modeled, I also refer to reforms in a very broad sense. One might therefore best think of si tas a vector of reform policies. It is assumed that structural reforms are time independent, thus distortions in each period are influenced by structural reforms in that period (see Beetsma/Jensen (2003)). This is not unrealistic because unemployment benefits, minimum wages or tax rates are often adjusted by governments on a yearly basis, and indicators of institutional quality also vary from year to year. Moreover, changes in the governing party might involve policy changes as incoming governments often turn back reforms previous governments have implemented. Finally, output is affected by open economy influences; a real devaluation increases foreign demand and thus output. Openness lis assumed to be equal in the two equal sized economies. Under flexible exchange rates, the exchange rate adjusts for inflation differentials, thus eãpHpL, so that the real exchange is constant and has no influence on output. Under fixed exchange rates, however, the real exchange rates varies with to differences in inflation. With these assumptions, output in the two countries is yL tãpL twL tþxL tsL t  lp LpHþe Èê :È2aê yH tãpH twH tþxH tsH t  þlp LpHþe Èê :È2bê The timing in each period is as follows: (i) the amount of structural reforms is determined, (ii) inflation expectations are formed, (iii) monetary policy is set, and (iv) inflation and output are determined. 5 I assume that governments are Stackelberg leaders vis-a-vis the central banks, but that they play Nash against each other. The model is solved by backward induction. Government preferences are given over an infinite horizon but are identical for each period. Governments aim to minimize differences between actual and potential output and to minimize deviations of inflation 200 Carsten Hefeker 4I thus distinguish, as in Campos/Kinoshita (2008), between reform efforts si t and reform outcomes ki tsi t. 5If the central bank would be able to commit to a policy rule, results would change because there would be no connection between structural reforms and the monetary regime. Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 from zero. Structural reforms are (politically) costly since they hurt certain interest groups or voters. The more reforms are implemented, the higher the costs for the government. Then, per period utility (in logs) for the government is vi tãby i t  2pi t  2cs i t  2 È3ê All parameters in the utility function are set equal for both countries because I wish to abstract from effects through monetary unification that are only due to differences in preferences. 2. Monetary Policy under Autonomy and Monetary Union Central bank preferences are similar to those of the respective government but without being concerned with the implementation of structural reforms. Since I do not focus on conflicts between central bank and government, the other utility parameters are set equal to those of the government. The period utility of the central bank is hence ui tãby i t  2pi t  2 È4ê Taking expectations as given, the central bank’s reaction function is mi tãb1 Èê Epi t  þki tsi t  =1þb Èê . Rational expectations imply EpH t  ã bk i tsi t  , so that in equilibrium mi tãb1 Èê ki tsi t  :È5ê If b>1, the central bank will run a more expansive monetary policy the higher are structural distortions in order to compensate for their negative output effect. If b<1, however, monetary policy will be contractionary in response to structural distortions because they lower output and thus money demand, which would increase inflation for a given money supply. Taking (1) into account, equilibrium inflation and output can be calculated as pi tãbk i tsi t  È6ê and yi tãki tsi t  È7ê Real Exchange Rates, Structural Reforms and Monetary Union 201 Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 Summarizing, we have: Result 1: Under monetary autonomy, the rate of money growth will increase in the degree of distortions if the central bank is sufficiently concerned with output. A very conservative central bank will contract money supply in response to high levels of distortions. Inflation is increasing and output is falling in distortions. In a monetary union instead, monetary policy is determined by a common monetary authority. The common central bank is concerned with average inflation and output, and its utility function is thus uCC tã pL tþpH t 2  2 byL tþyH t 2  2 È8ê where the relative weights of the two countries are equalized. I do not distinguish between economic and political weights (as in Berger (2007) or Hefeker (2008)) which would further complicate the analysis. I will discuss the influence of relative size below, however. Taking rational expectations into account, monetary policy is mtãb1 2kL tsL tþkH tsH t  È9ê The central bank’s policy leads to the following inflation in the two regions pi tã1þa Èê ki tsi t  þakj tsj t  12l;i;jãL;H;i6ã jÈ10ê with aãb1 Èê =2lb, which is positive if b12l Èê >1. 6 That is, the country must not be too open. The influence of openness on inflation is derived from @pi t=@l>0if ki tsi t  >kj tsj t  . Result 2: Under monetary union the rate of inflation will react equally strong to distortions in both countries, but the reaction to any single country is less than under monetary autonomy. Again, the central bank will accommodate wage demands and distortions if b>1. Whether openness has a positive or negative influence on inflation depends on relative distortions. 202 Carsten Hefeker 6Similarly, 1 þa>0ifb12lÈêþ1>0. Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 inal exchange rates this boosts domestic export which, in turn, lowers the pressure to implement reforms. Thus, the simple results derived in the earlier literature are not universally applicable and need serious qualifications. In addition, it is obvious that the strength of the countervailing effects is also a question of relative sizes because small partner countries have hardly any spillover effects. Thus, small countries are more affected through these effects than large countries. How results could be applied to predictions and policy conclusions is less clear. Quite obviously, categorizing particular countries as being more or less distorted depends on what type of distortions is concerned. Labor markets are arguably more distorted in some of the older member states and institutional quality may be worse in some of the newer member states. General conclusions are therefore hard to draw and this might also be an explanation why the empirical evidence is less than clear concerning the influence of EMU on reform efforts in member countries. It is obvious, though, that introducing even more disparities with enlargement will make simple predictions even more problematic. It is tempting to speculate about which countries might gain from enlargement of EMU. It would be those countries where distortions are below those of the accession countries (which is probably the case for many older members), while accession countries would probably all experience output losses. In this respect, an early extension of EMU to the Middle and Central European countries could be desirable because reform increasing for older members. If, however, governments oppose structural reforms, this result can be one explanation why enlargement is made conditional on convergence of the candidates. In contrast, extension could also result in a slowing down of reform efforts in those accession countries who experience an overall fall in inflation. Drawing conclusions beyond these general observations about who would agree to enlargement is difficult because I have assumed that preferences are similar in accession countries and present members. This is quite unrealistic; there are obvious differences among the present member states concerning aversion to reform, and probably also with respect to inflation and output gaps. Making predictions about voting behavior would therefore stretch the model too far since this is not only a question of preferences but of the degree of convergence and structural inflation at that time. Real Exchange Rates, Structural Reforms and Monetary Union 209 Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 The results have nevertheless direct implications for the current debate about the optimal exchange rate regime for accession countries. While it is widely debated whether accession country should unilaterally adopt the euro or whether they should float, my results suggest that a full membership in monetary union need not necessarily bring gains for accession country, which is usually assumed, but for current members since monetary union can lead to more structural reforms there. Indeed, enlargement could induces more structural reforms in current member states and be hence output increasing while having the opposite effect in accession countries. It is therefore not necessarily clear that the requirement of significant conversion before enlargement is in the best interest of present member states. Instead, one might argue that this requirement forgoes the chance of inducing more reforms and that an early accession might be preferable. References Bayoumi, T. /Eichengreen, B. (1996): Operationalizing the Theory of Optimum Currency Areas, CEPR Discussion Paper 1484. – Beetsma, R./Jensen, H. 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Real Exchange Rates, Structural Reforms and Monetary Union 211 Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17 Summary Real Exchange Rates, Structural Reforms and Monetary Union The paper addresses the question what effects the enlargement of a monetary union will have on necessary structural reforms in member countries with high and low degrees of distortions. I show that monetary union has asymmetric effects on reform efforts and under what circumstances governments increase their reform efforts. Depending on asymmetries in the degrees of distortions, the stance of monetary policy, and countries’ openness, one could expect convergence or divergence in reform efforts. (JEL E61, E63, F33) Zusammenfassung Reale Wechselkurse, Strukturreformen und Währungsunion Der Aufsatz untersucht die Frage, welche Konsequenzen die Erweiterung der Währungsunion haben wird auf die notwendigen Strukturreformen in Ländern mit größeren oder geringeren Verzerrungen. Er zeigt, dass die Währungsunion unterschiedliche Auswirkungen auf die Reformbemühungen haben wird und unter welchen Umständen Regierungen ihre Bemühungen erhöhen werden. Abhängig von den Unterschieden im Ausmaß der Verzerrungen, der Ausrichtung der Geldpolitik und der Offenheit der betroffenen Länder kann man eine Konvergenz oder Divergenz in den Reformbemühungen erwarten. 212 Carsten Hefeker Kredit und Kapital 2/2009 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.42.2.195 | Generated on 2023-01-16 13:34:17