ec4333: european economy topic 9: optimum currency areas

EC4333: European Economy

Topic 9: Optimum Currency Areas

EC4035: Economics of Integration

The Question

The question of a single currency in a large area Does it make good economic sense for each country

to have its own currency? What is the optimum size of a currency area?

Should currency area borders coincide with national borders?

Is it a good idea for California to be on the US dollar?


The (Economic) Answer

Benefits and costs involved in adopting a common currency

The solution has to involve trading off these costs and benefits


The (Economic) Answer


Focusing on Costs

No precise way of estimating costs (or benefits) so, in the end, a matter of judgement Benefits taken as given Look at the costs

Asymmetric shocks How they create trouble What makes them more likely What makes them less painful


In a Nutshell… The benefits Usefulness of a currency grows with the size of

the area over which it is used Money exhibits increasing returns to scale

The costs Loss of monetary and exchange rate instruments Matters in presence of:

Price and wage stickiness Asymmetric shocks


Basic Idea

Diversity translates into asymmetric shocks and the exchange rate is very useful for dealing with those shocks!

But, if you join a currency union…


A Demand Shock – Can the Exchange Rate Help?


Asymmetric Shock in a Currency Union


Asymmetric Shock in a Currency Union

After an asymmetric shock moving demand for country A from AD to AD' Country A wants a depreciation according to a new

equilibrium B, and real exchange rate λ1

Country B unhappy, as for the same real exchange rate it faces inflationary excess demand B''-B'

However, with unchanged real exchange rate λ0, country A faces excess supply A-A'


Implications of Asymmetric Shocks

Both countries are hurt when they share the same currency

This is an unavoidable cost Next questions

What reduces the incidence of asymmetric shocks? What makes it easier to cope with shocks when they

occur? The analysis develops six OCA criteria


Six OCA criteria Three classic (economic) criteria

Labour mobility (Mundell) Production diversification (Kenen) Openness (McKinnon)

Three political criteria Fiscal transfers Homogenous preferences Solidarity v nationalism


Criterion 1 (Mundell): Labour Mobility

In an OCA, labour moves easily across national borders


Criterion 1 (Mundell): Labour Mobility

Caveats Labour mobility is easy within national borders

(culture, language, legislation, welfare, etc.) Capital mobility: difference between financial and

physical capital In presence of country specialisation, skills also

matter


Criterion 2 (Kenen): Production Diversification

Countries whose production and exports are widely diversified and of similar structure form an OCA Indeed, in that case, there are few asymmetric

shocks and each of them is likely to be of small concern


Criterion 3 (McKinnon): Openness

Countries which are very open to trade and trade heavily with each other form an OCA

Distinguish between traded and non-traded goods Traded good prices are set worldwide A small economy is price-taker, so the exchange rate does

not affect competitiveness

If all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness


Criterion 4: Fiscal Transfers

Countries that agree to compensate each other from adverse shocks form an OCA

Transfers can act as an insurance that mitigates the costs of an asymmetric shock

Transfers exist within national borders Implicitly through the welfare system Explicitly in federal states


Criterion 5: Homogeneous Preferences

Countries that share a wide consensus on the way to deal with shocks form an OCA

Matters primarily for symmetric shocks Prevalent when the Kenen criterion is satisfied

May also help for asymmetric shocks Better understanding of partners’ actions Encourages transfers


Criterion 6: Commonality of Destiny

Countries that view themselves as sharing a common destiny better accept the costs of operating an OCA

A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interests This calls for accepting such economic costs in the name of a

higher purpose


Six OCA criteria Three classic (economic) criteria

Labour mobility (Mundell) Production diversification (Kenen) Openness (McKinnon)

Three political criteria Fiscal transfers Homogenous preferences Solidarity v nationalism


Overall

The OCA glass is half full, or half empty

Living in a monetary union may help fulfil the OCA criteria over time


In the End….

Monetary union is not only about economics!

ec4333: european economy topic 9: optimum currency areas

Documents

currency union slide

painful slide

national borders slide

costs asymmetric shocks

economic answer slide

currency area borders

single currency

common currency