Welfare Implications of the Design of a Currency Union in Case of Member Countries of Different Sizes

Frey, Rainer Article Welfare Implications of the Design of a Currency Union in Case of Member Countries of Different Sizes Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Frey, Rainer (2005) : Welfare Implications of the Design of a Currency Union in Case of Member Countries of Different Sizes, Kredit und Kapital, ISSN 1865-5734, Duncker & Humblot, Berlin, Vol. 38, Iss. 2, pp. 177-206, https://doi.org/10.3790/ccm.38.2.177 This Version is available at: https://hdl.handle.net/10419/293523 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/ Kredit und Kapital, 38. Jahrgang, Heft 2 Seiten 177-206 Welfare Implications of the Design of a Currency Union in Case of Member Countries of Different Sizes By Rainer Frey*'**, Frankfurt/M. I. Introduction Exchange-rate regimes had been widely discussed in the past and were again a subject of debate from the end of the 1980s and the beginning of the 1990s, especially with the launch of European monetary union (EMU). In 1992 the members of the European Union signed the Maastricht Treaty, which set out the schedule for establishing EMU. In January 1998 the single European currency was introduced in 11 countries. Latest, the expected enlargement lead to a rise in the interest in this field. The establishment of a currency union brings about the abolition of national currencies, which are strong national symbols (see Buiter (1999, p. 297)); however, the loss of sovereign national policies did not occur as a result of the launch of EMU; this had already happened to some extent with the establishment of the European Monetary System (EMS). Under the EMS, Germany set its own monetary policy, and many other European countries adopted the German policy in order to remain within the EMS. By contrast, the European Central Bank should conduct the policy that is most appropriate for the currency area as a whole (see OECD (1999, p. 11)). Topics related to EMU, ie the euro area, are highly relevant not only to Europe but also to the world as a whole. The euro area is one of the largest economic regions of the world with 307.8 million inhabitants in 2002. In comparison, 288.2 million people lived in the United States. Euro-area GDP reached EUR 7.1 billion while that of the USA was EUR 9.4 billion (see ECB (2004b, p. 7)). I am indebted to the participants of the ESEM conference 2001 in Lausanne (Switzerland) and of the research seminar at the University of Helsinki in December 2001, Seppo Honkapohja, Michael Rauscher and an anonymous referee for constructive criticisms. The paper represents the author's personal opinions and does not necessarily reflect the views of the Deutsche Bundesbank. Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 178 Rainer Frey Besides this study, there are already a large number of articles that treat the relevance of the optimum-currency-area criteria. As in this study, Aksoy, de Grauwe, and Dewachter (2002) consider different preferences in the various euro-area countries, different national monetary transmission processes and asymmetric shocks. Aksoy et al distinguish between three voting procedures: consensus rule in the Governing Council of the ECB, ECB rule with some national considerations, and a rule in which each representative takes a national view. As in this study, de Grauwe (2000) formally addresses the relevance of asymmetric shocks and differences in the monetary transmission processes. In decisionmaking either the member countries have the same weight or euro-wide aggregates are considered. Similarly, Gros and Hefeker (2002) question whether the supranational central bank of a monetary union should look at the euro-area aggregates or if it were better to minimise the average of national losses. Furthermore, von Hagen (2000a and 2000b) considers the relevance of the composition of the Governing Council to the decisions of the ECB. As below, Dixit (2001) addresses a central bank that commits itself to a weighted average of the most preferred policy rules of the member countries. In Gruner (1999), if the central bank considers aggregate variables of the currency area, a symmetric subgame-perfect Nash equilibrium arises. Provided the monetary decisions are taken by majority vote and the monetary decisions are taken by national centralbank presidents with national interests, two equilibria emerge. Either all wages in all countries rise by the same rate or half of the countries are high-wage countries and half of the countries are low-wage countries. Von Hagen and Siippel (1994) focus on the relationship between centralbank decisions and elections in the member countries. They find that elections should not occur in more than half of the member countries at one time; otherwise, the median voter of the central-bank council might take into account the political aspects of his own home country. Below, great weight is put on the relevance of the design of the objective function of the supranational central bank. The model allows for a flexible weighting of the central-bank board and of the group of national central-bank presidents within the central-bank council. Besides, the consideration of the relative sizes of the member countries and so of the degree of labour mobility are issues that have been neglected in large parts of the existing literature. However, these aspects have important implications as they make the composition of the central-bank council crucial for the welfare of the member countries and of the currency area as a whole in face of shocks. Starting out from this framework, the con- Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 179 duct monetary policy is readdressed for several output-shock scenarios. This is also done for different monetary-transmission processes and different relative preferences for the output objective across the member countries. Like quite a number of articles addressing central-bank policy, this paper is based on the approach provided by Barro and Gordon (1983). The starting point of the analysis is a quadratic social loss function with the inflation rate and the output level as its arguments.1 According to Svensson (2000), a 'symmetric inflation target' as reflected in the loss function by the squared deviation of the inflation rate from its desirable value is important to fight both inflation and deflation.2 Additionally, the central bank pursues an output target to moderate business cycles.3 Like the supranational-central bank, both member countries are assumed to minimise their loss functions that are squared in the output levels and in the inflation rates at home. Minimising the loss function, the central bank has to consider the constraint given by the inflationoutput trade-off, the Phillips curve (Phillips (1958) and Lucas (1976)). This paper is organised as follows. The structure of the model is presented in Section II. Section III presents the optimal inflation-rate rules depending on the composition of the central-bank council. With different shock scenarios, Section IV. derives welfare implications considering the relevance of the composition of the central-bank council, the monetary transmission processes of the two countries, differences in the preference parameters in the loss functions across the member countries, the relative sizes of the member countries and the degree of labour mobility. Section V. concludes. 1 In the derivations of the quadratic loss function, a second order approximation is applied to the utility function of a representative consumer (see Rotemberg and Woodford (1999), Woodford (2001) and Gall and Monacelli (2002)). 2 After an evaluation of its monetary policy in 2003, the ECB does not only aim to inflation rates below but also close to 2 % in the medium run what implies the intention of avoiding deflation too (see ECB (2004a, p. 50 and 51)). 3 In an empirical work, Clarida and Gertler (1996) found the Bundesbank to pursue output targets: "... we find that the performance of the real economy also influences its [of the Bundesbank] decision making. It adopts a gradualist approach to disinflating and it does ease when the real economy weakens." Clarida and Gertler (1996, p. 47). Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 180 Rainer Frey II. The Model 1. The Objective Functions of the Member Countries A currency union composed of two countries that are allowed to differ in size is addressed. Since the member countries assess the currency union with respect to, first, the national welfare criteria, the objective functions of the two member countries are introduced. These loss functions include the squared deviations of inflation and of output from their national targets.4 In the following, the targets are the same in the loss functions of the two countries and in that of the supranational central bank below Additionally, to limit the analysis, both countries face the same inflation rate:5 where Lt and hat are the losses of the domestic and foreign country, 7if is the union-wide inflation rate (the difference of the price levels in logarithms in period t and in period t — 1 ), yt (yis the logarithm of the domestic (foreign) output level in period t,iv* and y* are the socially desired levels of these variables, and 6(d) is the domestic (foreign) weighting parameter reflecting the preference of the domestic (foreign) society for the output objective vis-à-vis the inflation objective with b > 0 and 0 < d < 1 + 6. If d equals b, both countries have the same relative output preferences. If d exceeds 6, the foreign country is more concerned about output than the domestic country.6 4 Horowitz (1987) addresses the properties of the quadratic social loss function. 5 There may be two major sources for different inflation rates. On the one hand, national monetary-demand shocks cause discrepancies in inflation rates (see von Hagen (2000b, p. 225 and 226)). On the other hand, different national inflation rates are possible if the degree of economic development differs across countries. Provided the international productivity differentials are greater in the production of traded goods vis-à-vis those in the production of non-traded goods, inflation differentials are found across the countries (see Balassa (1964)). 6 Since the conduct of monetary policy and the assessment of the monetary regimes are based on the national loss functions, it is necessary to impose restrictions on the loss functions to avoid biased results in favour of one country. Therefore, the sum of the weights to the output and inflation objectives equals 1 + 6 for (i) (2) Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 181 2. The Objective Function of the Supranational Central Bank It is assumed that the central-bank council consists of a central-bank board and a group of national central-bank presidents. The loss function of the supranational central bank is the weighted sum of those of the board and of the group of presidents; the importance of the board vis-à- vis the national presidents is reflected by the parameter k: (3) Lf = kLb t oard + (1 - k)Lp t re\ where k is the weight of the loss suffered by the central-bank board, Lt°ard, and (1 -k) that of the losses of the national central-bank presidents, Lfes, with k e [0; 1]. The members of the central-bank board are assumed to observe the economic conditions of the currency area as a whole. In doing so, they address the weighted sum of the losses that occur in the member countries:7 (4) Lbrd = j[n[Kb« - *')2+b?(y, - y')2} + (1 - »)[6?W - n')2 +bf (jfi - j,')2]] with bf =n + (l -n)(l + 6-d) and bf = nb + (1 - n)d, and where b^and byb are the weights the central bank attaches to the inflation and to the output objectives, n G (0; 1) is the size of the home country relative to the size of both countries together and (1 - n) is the relative size of the foreign country. The weight of the data on a country in the central-bank board corresponds to the relative economic size of the country, n, as the establishment of a currency union is a decision taken for a long time horizon. each country. Thus, an increase in the parameter d not only stands for an increase in the foreign weight to the output objective but also for a decrease in the weight to inflation. 7 Besides, the board may consider a loss function including the aggregate values of inflation and output of the currency area. As this design makes the central bank suffer no loss as long as the aggregates are in equilibrium though there may be national disequilibria in the currency, it is not chosen here. In contrast, the objective function above may serve as a welfare measure of the currency area as a whole. Provided the national monetary transmission processes coincide, one single monetary policy rule applies for both central-bank board objective functions. Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 182 Rainer Frey Most probably, countries like to join a monetary union only if their weights are at least as high as their relative sizes in the union.8 The national central-bank presidents are interested only in their home economies and try to minimise the deviations of the national economic variables from their targets. They have equal weight in the decisiontaking regardless of the relative sizes of the countries they represent: (5) Lr=jLt + iL?. 3. The Monetary Transmission Processes in the Member Countries The transmission of monetary policy to the real economy is described by the Phillips-curve relationship. In the two countries the Lucas-type supply functions are given by9 (6) j/t = (7) # = with (8) aa = ca, where irfe is the union-wide inflation rate that is expected in period t— 1 for period t, and is the effect of an iid supply shock with mean 0 and variance (^((cr0*)2) at home (abroad), a and aa are the domestic and foreign sacrifice ratios of variations in surprise inflation to variations in output, c > 0 reflects potential differences in the monetary transmission processes between the domestic and foreign country. Output-inflation trade-offs may differ in the two countries; this is reflected by a value of c that is different from 1. 0<c<l(c>l) means 8 The weight in Dornbusch, Favero and Giavazzi (1998) corresponds to the ratio of its GDP to euro-area GDP Dixit's (2001, p. 603)) country weights are chosen according to relative economic sizes and political powers. 9 Here, output persistence is not considered. Output persistence would require the addition of the lagged output level on the right of equations (6) and (7) (see Lockwood, Miller and Zhang (1998)). Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 183 that monetary policy abroad is less effective (more effective) than at home.10 As in Svensson (1997), the natural output levels in the two countries are the unconditional means of the output levels, E(yt) and E(y%). These are set equal to zero. The market participants have rational expectations: (9) Trf =Et_i7rf , where Et-\ is the expectations operator conditional on information available in period t— 1. 4. Labour Mobility In the field of exchange-rate regimes Mundell's (1961) paper on optimum currency areas has already addressed the relevance of labour mobility. To deduce the implications of labour mobility for the economies and the national welfare levels it is necessary to explain how the labour market is related to the goods market. It is assumed that long-term output supply is accompanied by full employment. Consequently, negative output-supply shocks cause unemployment while positive supply shocks result in excess-labour demand. Migration relieves the labour market of the country in which a negative output shock occurs. Of course, if the effect of migration is positive for the country in which the negative supply shock occurs, there is a transfer of negative effects to the neighbouring country that has previously not suffered from output shocks. If there was full employment in the other country before, then the inflow of migrants would create unemployment provided wages were rigid.11 It is assumed below that the degree of labour mobility is the same in both countries. In the event of labour mobility the effects of the supply Dornbusch, Favero and Giavazzi (1998) attribute differences in the inflationoutput trade-offs between the euro-area countries to differences in wage bargaining, in particular. 11 The issue that migration can ameliorate the situation in one country while the other country is negatively affected is captured in the simulation model of Beine and Docquier (1998, p. 241 f.). Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 184 Rainer Frey shocks that the countries face after the completion of the migration process are the relocated effects of the initially national shocks:12 (10) et = (un + (1 - u))et' + u(l - n)ea t', (11) ea t = Ml - n) + (1 - u))e*' + unet', where et is the effect of supply shocks at home (abroad) after migration has finished, et' (£*') is the supply shock that initially occurs at home (abroad), and ue [0;1] is the degree of labour mobility: u = 0 stands for no labour mobility and u= 1 means perfect labour mobility. In equations (10) and (11) the parameter u reflects the degree of labour mobility. In the case of perfect labour mobility (u = 1) the negative effects of the shocks that initially occur in one country are relocated in proportion to the relative country sizes to both countries. When there is no labour mobility (u = 0), then the countries are solely confronted with the shocks that arise at home. The shock terms of the two equations above enter equations (6) and (7). III. Monetary Policy Dependent on the Composition of the Central Bank Council Here, only the scenario of central-bank commitment to an optimal policy rule is considered, and as the central bank takes the formation of expectations by the private sector into account, no inflation bias arises. Thus, the expected loss is minimised with respect to the actual and expected inflation rates:13 (12) min E{L?), subject to equations (1), (2), (3), (4), (5), (6), (7) and (9). 12 The presentation is similar to that of Bayoumi (1994). However, Bayoumi does not consider the relative sizes of the countries. In Bayoumi, the immigration of labour increases the output level in the region with excess demand for labour but labour-force emigration does not affect the output level in the country that faces unemployment. Since, in his analysis, welfare depends on consumption, immigration increases the welfare of the first country but the welfare of the second country is unchanged by the emigration of parts of the labour force. 13 The group of central-bank presidents takes decisions by the minimisation of the sum of the loss functions of the member countries. Thus, the decisions can be interpreted as the results of Nash bargaining games or votes taken under unanimity rule (see von Hagen (2000b, p. 222)). Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 191 differ in size, the central-bank board concentrates on the concerns of the larger country. In this way the loss of the central-bank board can be reduced. <25> d[ *KVar(et')) ) / ^ ^ 1 + W ^ °' t * (••"'") \ / b2a2fc(l - 4re(re - 1)) _ bb) Variations in the Expected Loss of the Home Country Without Labour Mobility However, Figure 5 shows that, under negatively correlated output shocks, as in cases where output shocks occur solely in one member country, the expected loss of a small member country is smaller the greater the weight of the group of national central-bank presidents in the decision-making process. If the monetary decisions are taken by the board, the maximum loss of a small country is larger than in the case of output shocks limited to one country since the small country is not only negatively affected by the effects of the shocks at home but also by central-bank policy that focuses on the contrasting stabilisation interests of the large neighbouring country (see equations (27) and (28) and Figure 5). Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 192 Rainer Frey (27) d{Var{et')) ' dn d),£»' = -£(', M=0 b2g2fc(l + fc - 2fcw) 1 + 6a2 <0, b2a2(l — 2n)(l + fc - 2fcn) 1 + ba2 <> 0. Figure 5 cc) Variations in the Expected Losses of the Central Bank and of the Home Country with Labour Mobility Under labour mobility, as in the scenarios characterised by the incidence of shocks in one of the member countries, it does not matter if the central-bank board or the national presidents take the monetary policy decisions. Both groups in the central-bank council have the same interests and would like to conduct the same monetary policies. If the two countries differ in size, the effects of the shock originating in the larger country also dominate the economic conditions in the smaller country. This means, for example, that, if there is a negative output shock in the large country while the small country is hit by a positive output shock, migration not only provides the workers needed by the small country to stabilise its economy but also that labour forces immigrate into the small country as long as the unemployment rates differ between the two countries. Under labour mobility, again, the figures of the expected losses of the central-bank council and of the home member country coincide (see Figure 6): Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 193 (29) 01 9(Var(e,')) 1 'dn 26(1 - 2re) 1 + ba2 <> 0, (30) d(Var(et')) dk Z^iL^X / = 0. Cb,£^' = -£f', U=1 3(Var(ft')) 0.04 : 0.02 Figure 6 3. Welfare Implications of Different Monetary Transmission Processes in the Member Countries Up to now, both countries have been characterised by equal monetary transmission processes. However, as introduced in Section 2.3, in the two member countries of the currency union, the impact of monetary policy on the output levels may be different. If, in equation (8), c is greater (less) than one, the monetary transmission coefficient is larger (smaller) abroad than that at home, ie a < (>)aa, and monetary policy abroad is more (less) efficient than at home.17 Since, in this section, the monetary transmission coefficient is allowed to change and since we continue to present the results in three-dimen- sional graphs, one parameter that has been free until now has to be fixed. Thus, consideration of the composition of the central-bank council Here, the parameter c is restricted to the interval c e [0.5; 2]. Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 194 Rainer Frey is limited to the two extremes in the following: a central-bank council that consists entirely of a central-bank board and a central-bank council that is formed entirely of national central-bank presidents. Owing to the complexity of the analytical results, only the graphical presentation of the results is provided. Output Shocks in the Home Country a) Variations in the Expected Loss of the Central Bank Without Labour Mobility Figure 7 shows the expected loss of the central-bank board if the monetary decisions are taken by the board itself. In Figure 8, by contrast, the expected loss of the group of national presidents is presented for the case where monetary policy is determined solely by the group of national presidents. Figures 7 and 8 We see that the expected losses of the two types of central-bank council increase in the inflation-output trade-off parameter abroad, c. The stabilisation of the domestic economy, which is hit by output shocks, is at the expense of some déstabilisation of the foreign economy. The higher the trade-off parameter abroad, the more costly is stabilisation of the home economy. In the end an increase in c is accompanied by less central-bank stabilisation policy and a greater expected loss by the central bank. Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 195 b) Variations in the Expected Loss of the Home Country Without Labour Mobility In Figures 9 and 10 it can be seen that the expected loss of the home country increases in the foreign inflation-output trade-off parameter. Then, the central bank reduces its efforts to stabilise the domestic economy since the cost of this policy, the déstabilisation of the foreign country, increases. In the event of central-bank decisions taken by a centralbank board (Figure 9), the greater the stabilisation efforts made, the larger the home country. Figures 9 and 10 c) Variations in the Expected Loss of the Central Bank with Labour Mobility Both types of central-bank council conduct stabilisation policy at low cost if the member countries of the currency union have high and similar inflation-output trade-off parameters. The central-bank board and the group of national central-bank presidents suffer their smallest losses if the monetary transmission coefficient abroad is higher than at home - c little higher than one. Then, in relation to the currency area as a whole, monetary policies become more effective than in case of equal transmission processes, c = 1, and the expected losses of both types of centralbank council decrease although somewhat less stabilisation policy is conducted than is preferred by the country with the lower monetary transmission coefficient (see Figures 11 and 12). Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 196 Rainer Frey 3(JSt.1Lf'min) Figures 11 and 12 d) Variations in the Expected Loss of the Home Country with Labour Mobility In contrast to the different types of central-bank council, the home country enjoys maximum welfare provided the neighbouring country has a similar transmission coefficient. This is valid both in the case of a central-bank council composed of a central-bank board and in the case of monetary policy decisions taken by the group of national presidents (see Figures 13 and 14). Then, the conduct of monetary policy is optimal with respect to the home country. aosv-iO d(Var(V)) 0.04: 0.03: 0.02-i 0.01 ^ 1 u=l,k=l d(Var(ft')) 0.06- 0.05- 0.04- 0.03- 0.02- 0.01 • u-l, k=0 nO.öX o- YTsTe14c Figures 13 and 14 Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 197 4. Welfare Implications of Different Output Preferences in the Member Countries In this section we investigate differences in the output and inflation preferences of the member countries of a currency union. In its loss function, the foreign country may attach more or less weight to the output objective than the home country, b < d or b > d in equations (1) and (2). These national differences affect the decisions of the supranational central-bank council since the national loss functions are fundamental to the central-bank objective function. The preference parameters in the loss function of the central-bank board are the country-size-weighted sums of the preference parameters of the two member countries. Besides this, the national central-bank presidents consider the loss functions of their home countries, which include the national preference parameters. As in the section above, output shocks at home are investigated, and monetary decisions are taken either by the central-bank board or by the group of national central-bank presidents. Output shocks in the home country a) Variations in the Expected Loss of the Central Bank Without Labour Mobility The expected losses of the central-bank board (see Figure 15) and of the group of national presidents (see Figure 16) are greater the higher the foreign preference for the output objective. This issue is especially relevant to the central-bank board if the foreign country is relatively large, which means that n is relatively small. Figures 15 and 16 Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 198 Rainer Frey The conduct of stabilisation policy with respect to the domestic economy hit by shocks is at the expense of some déstabilisation of the foreign economy. Although an increase in the foreign output-preference parameter is accompanied by a decrease in the inflation preference abroad, the shift in the weighting of the preference parameters results in a larger expected loss in the foreign country and, consequently, in a larger expected loss by the central bank. b) Variations in the Expected Loss of the Home Country Without Labour Mobility If the central-bank board takes monetary decisions (see Figure 17), the expected domestic loss is smaller the higher the output preference abroad. This outcome does not come as a surprise since, in the case of a higher output preference abroad, the output preference of the centralbank board, which is the relative size-weighted sum of the output-pref- erence parameters of the member countries, is also higher. Thus, the board increases its efforts to stabilise the domestic economy hit by output shocks even though the deviations from the targets abroad increase. The result differs if the group of national presidents takes the monetary decisions (see Figure 18). Here, the higher output preference of the foreign central-bank president results in a larger expected loss in the home country. The higher the output preference abroad, the larger the expected loss of the foreign country due to some déstabilisation of its economy, and therefore the group of national presidents decides to conduct less stabilisation policy with respect to the domestic economy. Figures 17 and 18 Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 Welfare Implications of the Design of a Currency Union 199 c) Variations in the Expected Loss of the Central Bank with Labour Mobility Under labour mobility, the foreign country is also directly affected by the shocks originating at home. In this case, both the expected loss of the board and the expected loss of the group of national presidents first increase before they decrease in a higher output preference of the foreign country (see Figures 19 and 20). First, an increase in the output preference abroad is accompanied by higher losses as this makes the board and the foreign central-bank president suffer more from deviations from the output targets. Afterwards, a further increase in d leads to a decrease in the expected losses of the two types of central-bank council owing to the greater stabilisation efforts of the central bank with respect to both economies while the further increase in the losses caused by larger deviations from the inflation target is relatively moderate. Figures 19 and 20 d) Variations in the Expected Loss of the Home Country with Labour Mobility In Figures 21 and 22 below we can see that, with both the decisions of a central-bank board and of a group of national central-bank presidents, the expected losses of the home country decrease if the output preference abroad increases. This is due to the increase in the efforts of the central bank with respect to the stabilisation of the two economies. Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15 200 Rainer Frey Figures 21 and 22 V. Conclusions The welfare implications of the design of a monetary union have been deduced under different output-shock scenarios. The central-bank council may consist of a central-bank board and a group of national centralbank presidents. While the board addresses the currency area as a whole in its decisions, here, the national presidents are assumed to be interested in their home economies only. We begin by turning to the attractiveness of a central-bank council consisting of both a central-bank board and a group of national centralbank presidents and start with the absence of labour mobility. For output shocks in one country and negatively correlated output shocks, the expected loss of the central-bank council is greatest in two cases. First, the loss is maximal if the two member countries of the currency union are of the same size and this is independent from the composition of the council. Then, little policy action is taken by the central bank. Second, in the case of a central-bank council composed solely of a group of national presidents, again little stabilisation policy is conducted owing to the equal weighting of the welfare of the two countries in the central-bank loss function. Next, in all output-shock scenarios, a small country prefers decisions to be taken by a group of national presidents while a large country favours monetary-policy decisions to be taken by the central-bank board. The small country opts for a strong position for the group of national presidents in the central-bank council since the more important the group of national presidents the more impact the small country has on the monetary decision process. In the case of the Kredit und Kapital 2/2005 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.38.2.177 | Generated on 2023-01-16 13:22:15