The Levin model of monetary integration

Résumé du document

In the following work the Levin model of monetary integration is going to be derived and then used to show that the union monetary expansion reduces income divergence between the countries in the union and that fiscal expansion in one of the countries increases income divergence. Also it is going to be shown that under the assumption of a constant total output of the two countries neither positive nor negative change in income divergence is a Paretto improvement.

The Levin model looks at the case of two countries creating a monetary union in the form of a common currency area. Let's assume that these two countries are European Union (EU) and United Kingdom (UK) and the rest of the world is just the one economy denoted W. Framework of the Levin model corresponds to the Mundell-Fleming model of an open economy with a freely floating exchange rate.

Extraits

[...] Application Expansionary monetary policy. If currency union adopts expansionary monetary policy it distorts money market equilibrium this in tern affects goods markets and as a result long run equilibrium values of exchange rate and income divergence change. Effect of the monetary expansion on the vertical intercept of the locus: So changes in the monetary policy do not affect the set of combination of the exchange rate and level of income divergence that correspond to the dynamic equilibrium in commodity market ( locus). [...]

[...] Output moves slowly relative to interest and exchange rates. Common currency union implies only common money market, while good markets of the two countries are independent of each other. Therefore static equilibrium in the union's commodity market is achieved when aggregate demand in each union country is met by that country's domestic supply/production. Equation 1.1 and 1.2 represent equilibrium condition for EU and UK commodity markets correspondingly. ( 1.1 ) ( 1.2 ) E aggregate expenditure income (production) a marginal propensity to consume nominal interest rate - inflation G government spending 1 sensitivity of export to the activity level in the partner country 2 - sensitivity of the net export to the exchange rate 3 marginal propensity to import 5 T trade shock The model is focused on the dynamics of the EU and UK income divergence. [...]

[...] Effect of the fiscal expansion in EU on the vertical intercept of the locus: . Therefore increase in government spending differential shifts the locus upwards. This shift is shown on the Graph 3. Increase in G shifts locus from the position ( into ( )1. Effect of the fiscal expansion in EU on the vertical intercept of the locus: So changes in the fiscal policy do not affect the set of combination of the exchange rate and level of income divergence that correspond to the dynamic equilibrium in the money market ( locus). [...]

[...] New long run equilibrium level of income divergence, Y2* is smaller than initial level Y1* so increase in money supply results in a decrease in income divergence Y2* during the transitory period change in income divergence is negative). At the new equilibrium exchange rate is greater than it used to be so expansionary monetary policy results is depreciation of the domestic currency and therefore increases competitiveness of the domestic goods on the international market. Fiscal expansion in UE. It was assumed that therefore increase in government spending in UE while UK level of government spending is constant will result in increase in the government spending differential. [...]

[...] Hansen and J. U-M. [...]