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1 The Difference in Development Stages and the Costs of Monetar Union A New Open Econom Macroeconomics model VDF Toko Feb 10, 2007 Vu Tuan Khai Outline of the presentation 1. Introduction 2. The difference in development stages - A sectoral point of view. 3. The model 4. Calibration results and the transmission mechanisms of shocks 5. Concluding remarks 1

2 Introduction (1) Recentl there has been a wide discussion of introducing a common currenc (CC) for East Asia, which is motivated b the following factors: The recognition of the vulnerabilit of the unilateral dollar-peg regime after the Asian crisis The rapidl-prevailing economic integration in the region The successful launch of the euro in Europe Introduction (2) In this discussion, it is often argued that a CC would be difficult for East Asia because countries in the region are at different development stages. It is not clear wh? In addition, how to define the difference in development stages is also an important issue. 2

3 The Costs of Monetar Union (1) According to the theor of Optimum Currenc Area, One of the main costs of MU is the cost arising when the countries have to give up their monetar polic autonom. This cost will be relativel small if shocks occurring in these countries are smmetric. The Costs of Monetar Union (2) This argument takes for granted the condition that the economies respond similarl to a smmetric shock. This condition ma not hold if the countries are at different development stages because the have different economic structures. Then, the problem is when the countries are at different development stages, what happen to their responses to a smmetric shock. 3

4 This paper (1) Gives an explicit definition of the concept difference in development stages b looking at the differences in sectors between the countries. Based on that, builds a theoretical model that is suitable to analze the effects and the transmission mechanisms of various kinds of smmetric shocks. This paper (2) The model in this paper differs from other models built so far in the NOEM literature in one main point: It emphasizes the importance of resource allocation across sectors to the transmission of shocks. It also has some advantages over existing empirical studies on CCA in East Asia in two points. - able to specif the transmission mechanism of shocks. - able to stud the CC regime which does not exist et in the region. 4

5 The difference in development stages -A sectoral point of view (1) GDP per capita of East Asian countries , in constant USD N HKG SGP KOR MYS A 0 CHN PHL Year IDN VNM The difference in development stages -A sectoral point of view (2) GDP per capita in constant USD N KOR MYS A CHN PHL IDN VNM

6 The difference in development stages - -A sectoral point of view (3) Agricultural emploment share in total emploment 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% N KOR MYS A CHN PHL IDN VNM The difference in development stages -A sectoral point of view (4) The share of agriculture in GDP 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% N KOR MYS A CHN PHL IDN VNM

7 The difference in development stages -A sectoral point of view (5) Value added per worker in agricultural and industrial sectors in USD N KOR MYS A CHN PHL IDN VNM 1992, agriculture 1992, industr 1997, agriculture 1997, industr The difference in development stages - -A sectoral point of view (6) Summarize: in comparison with a developed countr, a developing countr will - have a relativel large agricultural sector in terms of both output and emploment. - have technolog level which is lower in industrial sector, and much lower in agricultural sector. - have an excess of labor in the agricultural sector (from the development experience of Japan in the past and China and Vietnam toda). 7

8 The difference in development stages - -A sectoral point of view (7) Differences between agricultural and industrial sectors - Agricultural goods are better substitutes of one another than industrial goods. - Prices are more flexible for agricultural goods than for industrial goods The NOEM literature (1) -The model of Obstfeld and Rogoff (1995) A dnamic structure Micro-foundation: taking into account the behavior of each individual household and firm Monopolisticall competitive firms Nominal rigidities in the short run The adustment to shocks are described in 3 periods: the stead state, short run and long run. 8

9 The NOEM literature (2) -The model of Obstfeld and Rogoff (1995) Two countries, which are completel smmetric in structure (except for population). One sector Consumer-laborer-producer setting This paper (3) Inherits the main characteristics noted above. However, extends to two sectors, namel the agricultural (T) and industrial (M) sectors, which are different in - technolog level, - elasticit of substitution between goods, - degree of price rigidit 9

10 This paper (4) The two countries, namel the developed and developing countries are now different in man aspects such as - the relative size of sector, - technolog level, - the degree of labor excess in the agricultural sector The assumption consumer-laborer-producer is revised to allow labor to move across sector. The model (1) The world consists of two countries, and. Each econom has two sectors, T and M. All goods are traded Labor is freel mobile domesticall, but not internationall. There are no restrictions or impediments to capital mobilit across countries. There are households, firms and the government in each countr. 10

11 The model (2) The (representative) household maximizes its lifetime utilit function given below, with the periodic utilit = = t U ( x ) βu( x ) 0 t 0 κ 2 M( x) ux ( ) = ln C( x) hx ( ) +χln 2 P under the budget constraint M( x) + PB( x) = (1 + r ) PB ( x) + M ( x) PC( x) PT( x) t t t t 1 t t 1 t 1 t t t t t + Wh( x) + γ ( z ) + (1 γ ) ( z ) T, M, t t T, t T, t The model (3) The household s consumption basket comprises of agricultural and industrial goods of and (CES function) C( x ) = ( C( x )) + ( C( x )) (1 ρ)/ ρ (1 ρ)/ ρ T M ρ/(1 ρ) where T, T, T, T, C( x ) = c( x, z ) dz + c( x, z ) dz T T, T, z z ( θt 1)/ θt ( θt 1)/ θt θt /( θt 1) C( x ) = c( x, z ) dz + c( x, z ) dz ( θm 1)/ θm ( θm 1)/ θm M, M, M, M, M M, M, z z θm /( θm 1) 11

12 The model (4) The government consumes goods in the same wa as the household. Its budget constraint is as follows, G t M M t t 1 = + T( x ) t P t The model (5) The monopolisticall competitive firm with the following production function z,,, ( k ) [ ( k α = A h z )] k k, maximizes its profit given below, = +,,, /,,, ( z k ) pz ( k ) z ( k ) S f pz ( k ) z ( k ) Whz ( k ) f f 12

13 The model (6) Market equilibria T, M, Labor market hx ( ) = γ hz ( ) + (1 γ ) hz ( ) T, T, UIP S f 1 + i = (1 + i ) t t S / f t+ 1 / f t Bond market Fisher equation nb + (1 n) B = 0 P t+ 1 f 1 + i = (1 + i ) t t Pt The common currenc regime S = 1 / f t The model (7) Put all equations derived above and solve for the stead state (SS)(where the amount of bond holding is zero in both countr). In the presence of a shock the dnamics of the econom are described b three period: the SS, the long run (new SS), and the short run (the adustment period). Four kinds of shocks are generated: tech. shocks to sectors M and T, monetar and gov. spending shocks. All shocks are positive (with an amount of 1%), permanent and smmetric to both countries. 13

14 Quantitative method: The model (8) Since it is difficult to solve for the solution analticall, a numerical method is adopted. The numerical method adopted in this paper has one strong point in that it can solve for the exact solution without linearizing. Main findings Results (1) Table 2-4 Case 4: All asmmetries together A = exp(0), A = exp(1.2), A = exp(1.0), A = exp( 2.8) T, T, M, M, α = 1, α = α = α = 0.5 γ T, T, M, M, = 0.5, γ = 0.2 T, T, 1% of mone suppl shock 1% of technolog shock in sector M 1% of technolog shock in sector T 1% of gov. spending shock SR LR SR LR SR LR SR LR Real GDP of -0.01% 0.00% 0.20% 0.22% 0.71% 0.68% 0.09% 0.10% Real GDP of 0.83% 0.00% 0.02% 0.86% -0.04% 0.08% 0.21% 0.06% 14

15 Main findings Transmission mechanisms of shocks (2) The case of a smmetric technolog shock to the industrial sector A, A M, M,, given d d M, M, p, p M, M, fixed d d h, h W, M, M, labor moves M T relative size ( M/ T) > ( M/ T) W LR demand rises due to consumption smoothing motive, M, T,, M, T, demand shifts M T ( p/ p ) T M markup principle firms in T, face increasing MC demand shifts T, T, p T,,, p T, relative size ( M/ T) > ( M/ T), T, T, ( p / p ) T, T, α the smaller in reduces the extent to which falls p T, Main findings Transmission mechanisms of shocks (3) The case of a smmetric technolog shock to the agricultural sector A, A T, T, pt flexible p T p M fixed ( p/ p ) T M ( p / p ) T, T, markup principle W, W relative size ( M/ T) > ( M/ T) demand shifts M T LR, T, T, demand shifts T, T, h h d M, T, d, h d, h d M, T, labor moves M T firms in T, face increasing MC demand rises due to consumption smoothing motive, M, T,, M, T, 15

16 Main findings Transmission mechanisms of shocks (4) The case of a smmetric mone suppl shock M, M p T p M flexible fixed p T ( p/ p ) T M ( p / p ) T, T, markup principle W, W, relative size ( M/ T) > ( M/ T) demand shifts T M, T, T, demand shifts T, T, h d, h d M, T, labor moves T M h d, h d M, T,, M, T,, M, T, Concluding remarks This paper builds a theoretical framework to give an answer to the question of how the difference in development stages affects the costs of monetar union. It finds that smmetric shocks, especiall technolog and mone suppl ones, can cause ver different responses between the developed and developing countries which the hit. Also, in comparison with the long run, the responses in the short run predicted b the model are surprising. The results show that the difference in development stages is an important issue and should be taken in to account when considering forming a CCA. 16

17 Concluding remarks In a future work, I shall tr to extend the model to a three-countr version will a full dnamic structure and using data to estimate parameters such that the reflect better the realit in East Asia. Thank ou! 17