Macroeconomic Analysis course

Nova School of Business and Economics

3 December 2012

Ariane Dinis (532)

Isabel Felino (274)

Marta Costa (531)

“ What are the challenges posed by

OCA theory on the European EMU?”

Agenda and Motivation

Francesco Mongelli (ECB)

research from 2002 to 2006

Optimal Currency Areas

- Definition and Evolution

- Endogeneity paradigms

European Monetary Union

- Overview and Prospects

• OCA Theory and properties 60s – 70s

Pioneering phase

• Inconclusiveness of diverse proprieties combined

• CBA vs OCA properties

70s

Reconciliation phase

• Reinterpretation of proprieties

• Reassessment of benefits and costs

• The balance in favor of EMU

80s-90s

Reassessment phase

• Theory subject to empirical analysis

80s-present

Emprirical phase

Theory of Optimal Currency Areas

OCA properties

OCA properties

Price and wage flexibility,

Mobility of labor and other factors of production,

Financial market integration,

Economic openness,

Diversification in production and consumption,

Similarity in inflation rates,

Fiscal integration and political integration.

Optimum currency area (OCA): optimal geographical area for a

single currency, or for several currencies, whose exchange rates are

irrevocably pegged. The single currency, or the pegged currencies,

fluctuate jointly vis-à-vis other currencies.

Why is the OCA theory relevant for

the EMU?

The implication for the European Economic and Monetary Union

(EMU) is that Euro Area may, overtime, turn into a Optimal

Currency Area (OCA ) after the Monetary Union

Endogeneity of OCA Flexibility

(Monetary Integration)

Income Correlation

(Symmetry)

Integration

(Openness to Trade)

Sources

Endogeneity of Financial Integration

Endogeneity of Symmetry of shocks

Endogeneity of Labor and Product Markets

Flexibility

(Monetary Integration)

Income Correlation

(Symmetry)

Integration

(Openness to Trade)

Endogeneities: Market-based

Endogeneity of Symmetry of shocks

Financial Integration

Risk Sharing Business cycle Synchronize

Less national Specialization

Symmetric shocks

Flexibility

(Monetary Integration)

Income Correlation

(Symmetry)

Integration

(Openness to Trade)

Endogeneities: Market-based

Endogeneity of Financial Integration

Financial instruments

Allocation Capital (FDI)

Equity Income

insurance

Exogeneity of OCA

Institutional integration

Economic integration

Structural Rigidities:

-labour market institutions

- Product market regulations

- Financial market integration

OCA theory: “OCA theory in reverse” – distinguish countries underperform under some OCA properties

Endogeneity of Labor and Product:

- Estabilished indicators and reforms (flexibilize and uniformize) OECD Job Strategy,

- Lisbon Agenda Four areas : 1. Improving knowledge and innovation; 2. Making the EU an attractive area to invest and work; 3. Fostering growth and employment (social cohesion); 4. Promoting sustainable development and human capital.

Exogeneity of OCA

Institutional integration

Economic integration

• Inflation dispersion among euro area is stabilised at extremely low historical levels

• Euro area inflation differentials are quite persistent over long periods

Inflation

Interest Rates

• Real long-term interest rates are now quite low and stabilised

• Persistent real interest rate differentials depend mainly on the persistent of inflation

Real Exchange Rate

• Divergences in price and cost competitiveness can still occur

• Appreciations of REER has led to losses in export shares

From the data to OCA to EMU Base Convergence on the OCA Theory:

- Significant financial Integration is necessary (but only concern?)

The EMU still has structural weakeness:

- Doesn’t take into account political forces

The OCA theory explain effects until 2006.

Financial crisis enhanced the weakeness of a large dependency financial

system

Endogenous responses: strong enough to improve the adjustment process

and reduce disturbances

- Drawback: exogenous institutional framework to improve market

flexibility is necessary.

Expectations?

Conclusion

The current crisis has been the most critical stage for the Euro area. The ECB have been effective and powerful to maintain price stability. But, exiting of the crisis will depend on the success of the economic and

institutional reforms.

Currently: reforms towards calming tensions in sovereign debt markets: credibility of financial institutions and governments.

Coming years debate on: economic and political frameworks, risks emanating from global imbalances, need for further international coordination and cooperation.

The various reform processes must be given the time and confidence needed to display they effects.

Discussion

• What do you think is going to be the future of the Euro?

• Is the OCA the main framework to be analyzed when a country

decides to enter or not in the Currency Union?

• Will be converge to a Optimal Currency Area as described above?