ec4333: european economy topic 9: optimum currency areas
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EC4333: European Economy
Topic 9: Optimum Currency Areas
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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?
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EC4035: Economics of Integration
The (Economic) Answer
Benefits and costs involved in adopting a common currency
The solution has to involve trading off these costs and benefits
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EC4035: Economics of Integration
The (Economic) Answer
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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…
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EC4035: Economics of Integration
A Demand Shock – Can the Exchange Rate Help?
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EC4035: Economics of Integration
Asymmetric Shock in a Currency Union
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EC4035: Economics of Integration
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'
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
Criterion 1 (Mundell): Labour Mobility
In an OCA, labour moves easily across national borders
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
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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EC4035: Economics of Integration
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
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EC4035: Economics of Integration
Overall
The OCA glass is half full, or half empty
Living in a monetary union may help fulfil the OCA criteria over time
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EC4035: Economics of Integration
In the End….
Monetary union is not only about economics!