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?

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

EC4035: Economics of Integration The (Economic) Answer

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

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

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…

EC4035: Economics of Integration A Demand Shock – Can the Exchange Rate Help?

EC4035: Economics of Integration Asymmetric Shock in a Currency Union

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 λ 1 Country B unhappy, as for the same real exchange rate it faces inflationary excess demand B''-B' However, with unchanged real exchange rate λ 0, country A faces excess supply A-A'

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

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

EC4035: Economics of Integration Criterion 1 (Mundell): Labour Mobility  In an OCA, labour moves easily across national borders

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

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

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

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

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

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

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

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

EC4035: Economics of Integration In the End…. Monetary union is not only about economics!