Optimal Currency Area - Eurozone

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As the eurozone is one of the world's newest and largest currency areas in the world, much research was and is focused on whether the Eurozone is an Optimal Currency Area.

In economic theory the degree of fullfillment of the following four criteria indicate whether an area is optimal for a monetary union. These criteria are often called the optimum currency area (OCA) criteria. Although these criteria are not exhaustive and far from absolute, they are generally accepted as a sufficient measure. There are three economic criteria (labour and capital mobility, product diversification, and openness) and one political criterion (fiscal transfers). All these criteria stand in relation to the ability to deal with asymmetric shocks (i.e. shocks that only hit one area). Symmetric shocks are less problematic in a currency area as the currency will depreciate or appreciate to the needed level for all areas (as this level is the same for all areas), while asymmetric shocks will create an exchange rate that is too high for one area and one that is too low for the other. This causes wage and price changes and unemployment problems. This problem is often worsened in reality as wages are fixed by social regulations, thus increasing unemployment even more.

(This page is mostly based on Baldwin, Richard & Wyplosz, Charles, The Economics of European Integration'', New York: McGraw Hill, 2004.)

Contents

1 Capital and labour mobility (Mundell)
2 Product diversification (Kenen)
3 Economic openness (McKinnon)
4 Fiscal transfers
5 References
6 See also

Capital and labour mobility (Mundell)

Mundell (1961) defined the mobility of factors of production including labour as the first criterion. High factor market integration and sufficient factor mobility within a group of partner countries can reduce the need to alter real factor prices, and the nominal exchange rate, between countries in response to disturbances. If one country suffers from depression due to a negative shock, factors of production may move from this country to another which is hit by a positive shock. Hence, prices of these factors do not need to fall so sharply in the depressed country and rise in the booming country. The factor mobility is then able to compensate for the exchange rate changes.

However, this earlier model was based upon post-war Keynesian assumptions. Mundell presumed that people had their expectations stationary, in other words they did not anticipate future movements in the price level, interest rates, the exchange rate, or in government policy itself. McKinnon has recently rediscovered two important Mundell’s papers published in 1973 and drawn attention to the later model.2 In one of these papers Mundell (1973a) admitted existence of private agents’ expectations and showed one important fact that better reserve pooling and portfolio diversification can mitigate asymmetric shocks within countries using a common currency.

A country hit by an adverse shock can better share the loss with a trading partner because both countries hold claims on each other’s output in a common currency. And the larger the portion of currencies that is backed up by internationally acceptable money the greater the reserve needed for unexpected events. Therefore, if some countries decide to form a currency area the domain of risk sharing is extended. A common currency area thus provides benefits for its members by offering insurance against region-specific shocks.

Product diversification (Kenen)

Peter Kenen meant by the product diversification criterion that the production and exports of the areas that form one currency area should be widely diversified. Furthermore production and export should have a similar structure between these areas.

A high diversification in production and consumption diminishes the possible impact of shocks specific to any particular sector. Therefore diversification reduces the need for changes in the terms of trade via the nominal exchange rate and provides “insulation” against a variety of disturbances. More diversified partner countries are more likely to endure small costs from forsaking nominal exchange rate changes amongst them and find a common currency beneficial.

While all eurozone members have a widely diversified production and export structure, not all eurozone members have a similar production and export structure. The two notable exceptions are the Netherlands and Greece. These dissimilar structures find to a certain extent their origin in the dependence on the production of natural gas in the Netherlands and the major role of agriculture in Greece.

In general however, this criterion is sufficiently fulfilled. The evidence gathered so far seems to indicate that the monetary integration has increased the diversification of production structures, thus further improving the performance of the EMU.

Economic openness (McKinnon)

Another criteria, designated by McKinnon (1963), is the degree of economic openness. The higher the degree of openness the more changes in international prices of tradables are likely to be transmitted to the domestic cost of living. Also devaluation would be more rapidly transmitted to the price of tradables and the cost of living, negating its intended effects. Hence, the nominal exchange rate would be less useful as an adjustment instrument for small and open economies.

Fiscal transfers

References