The theory of Optimal Currency Areas

© Baldwin&Wyplosz 2009 The Economics of European Integration, 3 rd Edition

The theory of Optimal Currency Areas

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The question of a single currency in a large 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: Optimum Currency Areas

• Joining a monetary union involves benefits and costs

• Benefits and Costs involved in adopting a common currency.

• The solution has to involve trading off these benefits.

• Major themes in cost-benefit debate:– Absorption of asymmetric shocks– Restoration of external price competitiveness


Theory of Optimum Currency Areas• Economic Integration and the Benefits of a

Fixed Exchange Rate Area: GG Schedule– Monetary efficiency gain

• The joiner’s saving from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float.

• It is higher, the higher the degree of economic integration between the joining country and the fixed exchange rate area.

– GG schedule• It shows how the potential gain of a country from

joining the euro zone depends on its trading link with that region.

• It slopes upward.


Degree of economic integration between the joining country and the exchange rate area

Monetary efficiency gain for the joining country

GG

Theory of Optimum Currency Areas


Theory of Optimum Currency Areas• Economic Integration and the Costs of a Fixed

Exchange Rate Area: The LL Schedule– Economic stability loss

• The economic stability loss that arises because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.

• It is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins.

– LL schedule• It shows the relationship of the country’s economic

stability loss from joining.• It slopes downward.



Degree of economic integration between the joining country and the exchange rate area

Economic stabilityloss for the joining country

LL


Theory of Optimum Currency Areas• The Decision to Join a Currency Area: Putting the GG and LL

Schedules Together

– The intersection of GG and LL • Determines a critical level of economic

integration between a fixed exchange rate area and a country

• Shows how a country should decide whether to fix its currency’s exchange rate against the euro



LL

GG

Gains exceedlosses

Losses exceedgains

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Degree of economic integrationbetween the joining country andthe exchange rate area

Gains and lossesfor the joining country


Focusing on Costs

• The costs of giving up monetary policy and the exchange rate matter especially in the presence of:

• Price and wage stickiness

• asymmetric shocks.

• Look at the costs:– No precise way of estimating costs and benefits so, in the end, a

matter of judgement.

• Look at asymmetric shocks:– how they create trouble

– what makes them more likely

– what makes them less painful.

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Adverse demand shock

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Rel. price or real exch. rate

S

D

D’

AC

B

GDP


Absorption of asymmetrical shocks

Demand shift from French to German goods, effects: France: declining production, higher unemployment, pressure for lower wages and lower prices Germany: rising production, inflationary pressures

In the absence of an EMU, there would be a devaluation of FRF and a revaluation of DEM (fixed exchange rate), resulting in:

cheaper French exports in Germany and more expensive German exports in France Rising demand for French goods and declining demand for German goods Return to initial equilibria prevailing before asymmetric shock


Implications of Asymmetric Shocks in EMUs

• Both countries are hurt when they share the same currency.

• This is an unavoidable cost.

• SO:– what reduces the incidence of asymmetric shocks?– what makes it easier to cope with shocks when they occur.

• The analysis develops six OCA criteria.

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Six OCA criteria

• Three classic (economic) criteria– Mundell

– Kenen

– McKinnon

• Three political criteria

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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.

– Labour mobility should in fact be interpreted as “labour market flexibility” encompassing not only geographical labour mobility, but a host of other elements (see next slide)

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Labour Market Flexibility


Criterion 2 (Kenen): Production Diversification

• Countries whose production and exports are widely diversified and of similar structure form an OCA.

– Produce similar goods (so shocks are symmetric), but a wide range of goods (so shock are less likely to occur)

– Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern.

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Criterion 3 (McKinnon): Openness

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

• Distinguish between traded and nontraded 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.

• EAPA=EBPB

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Criterion 4: Fiscal Transfers• Countries that agree to compensate each other for adverse shock

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.

• European Financial Stability Facility (EFSF), June 2010

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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.

• Inflation or employment?

• Exporters or consumers?

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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.

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Is Europe An OCA? (Asymmetric shocks)

• OCA index: Based on past experience, how much would European countries have adjusted their exchange rates vis-à-vis the German Deutschmark to deal with asymmetric shocks?

• Incorporates three classic economic OCA principles of Mundell, Kenen and McKinnon


Is Europe An OCA? (Asymmetric shocks)


Is Europe An OCA? (Openness)

• Small country, very open to trade exchange rate not a useful tool to deal with an asymmetric shock

• Openness: share of economic activity devoted to international trade; exports/GDP and import/GDP


Is Europe An OCA? (Openness)


Is Europe An OCA? (Diversification and dissimilarity)


Inside the OCA Index: Labour Mobility

• Low internal EU labour mobility

• EU must factor in many migration costs:– moving costs

– risk of becoming unemployed

– longer run career opportunities

– family prospects

– eligibility to welfare

– taxation

– cultural/linguistic differences

– national attachment.

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Migration


Inside the OCA Index: Transfers

• The EU does not satisfy the transfer criterion.

• The overall EU budget:– is low, slightly over 1% of EU GDP

– entirely used for administration, CAP, regional and structural funds.

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Inside the OCA Index: Homogeneity of Preferences

• Little is known about this criterion.

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Inside the OCA Index: Solidarity vs Nationalism

• Little is known about this criterion.

• Tendency of new member states to support joint decision-making more than Nordic countries

• Nationalism does not overall exert powerful influence.

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Overall

• The OCA glass is half full, or half empty.

• Living in a monetary union may help fulfill the OCA criteria over time.


In summary: policy dilemma of an EMU


Will Trade Deepen?

• Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot:– Baldwin et al (2008) shows euro to have increased trade by 5%

so far

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Will Diversification Grow or Decline?

• Argument 1: intra-industry trade will grow.

• Argument 2: specialisation will increase.

• No firm conclusion so far.

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EMU and Labour Markets• Mobility may not change much, as labour markets remain

rigid with unemployment protection

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Are the Other Criteria Endogenous?

• Transfers:– European Stability Mechanism (ESM) to replace EFSF mid-2013

• Homogeneity of preferences and Commonality of destiny:– no presumption that it will change soon.

In the end: Monetary union is not only about economics!

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The theory of Optimal Currency Areas

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