EC4333: European Economy

1. EC4333: European Economy Topic 9: Optimum Currency Areas

2. 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

3. 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

4. The (Economic) Answer EC4035: Economics of Integration

5. 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

6. 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

7. 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

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

9. Asymmetric Shock in a Currency Union EC4035: Economics of Integration

10. 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' EC4035: Economics of Integration

11. 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

12. 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

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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

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