optimal currency area theory

8/7/2019 Optimal Currency Area Theory

1/14

EUROPEAN ECONOMICS:

OPTIMAL CURRENCY AREA

THEORY


2/14

COSTS OF CURRENCY UNION

Analysis based on Asymmetric Shocks: Positively

shifts AD in one region and negatively shifts AD

in another.

Four Possible Methods of coming back from that:

I : Wage Flexibility (shifts the SRAS)

II: Labour Mobility (shifts the LRAS)

III : Fiscal Federalism (shifts AD) IV : Exchange Rate Manipulation (shifts AD,

acts via competitiveness)


3/14

WAGE FLEXIBILITY

Wages are not very

flexible in the

Eurozone; largely due

to the power of unions,as show in the diagram.

Most EU countries are

concentrated in the

middle; at the far right

there is only one unionand will thus lower

wage demands to

ensure maximum

coverage.

Wage Demands

Number of Unions


4/14

LABOUR MOBILITY

Labour mobility in the EU is low compared to

other OCA, such as the US.

However, it is not just low between countries, it

is also low within countries; it is also importantto note that there are no legal barriers to

migration, but culture and language act as stiff

informal barriers.

In addition, studies have shown that after

exchange rates have become fixed, labour

mobility rises to take up the slack, in application

of the Lucas Critique.


5/14

FISCAL FEDERALISM

Highly politically sensitive issue.

The fear is that there will be an extension of themezzogiorno problem; in Italy there is a system oftransfers from the productive and prosperous Northto the less prosperous South.

They have acted in such a way as to reduce incentivesfor labour mobility, thus creating a system ofdependency.

Problem has become such that there have emergedparties which call for the separation of the two

regions of Italy. Thus, Fiscal federalism may lead to conditions ripe

for MORAL HAZARD.

In addition, a study has shown that the impact ofFiscal federalism is about the same as the impact ofAutomatic Stabilisers; thus, it is desirable to not

choke Auto. Stab.


6/14

EXCHANGE RATE FLEXIBILITY THREE problems with changing

Exchange Rates.

1) Competitive devaluations arefrowned upon due to the beggar-thy-neighbour aspect to them.

2) They may not have a long-runimpact due to real wageresistance. After a devaluation,imports become more expensiveand SRAS shifts back up asworkers demand higher wages.Thus, another devaluation isneeded, and the vicious cyclerepeats itself, leading to everhigher inflation.

However, this degree of passthrough depends on the relativeimportance of import markets inthe economy.

3) Devaluations do not tackle thecause of the shock.

In addition, depends on the

degree of openness.

Price LRA

S

SRAS

SRAS

AD

AD


7/14

LIKELIHOOD OF ASYMMETRIC SHOCKS

Two views: European Commissionand Krugman

EC view: As integration increases, sowill symmetry (i.e., top diagram)

Krugman view: As integrationincreases, industries will tend tocollate in specific regions due togeographical external economies ofscale. Thus any industry specificshock will turn into a country-specificshock.

Two views shown in the diagrams.

The EC is the prevalent argument; asintegration increases, stateboarders become less important

in constraining activity, soindustrial areas may straddlenumerous states.

In addition, there is a risingimportance of services relative tomanufactures, dulling the Krugmanargument.

Finally, empirical evidence

indicates an upward slopingcurve.

EuropeanCommission

Krugman

Integration

Symmetry


8/14

BENEFITS OF ACOMMON CURRENCY

1. Removal of Transaction Costs:

This is a Pareto Improvement (the loss imposed by transactioncosts are a deadweight loss).

Should also lead to increased PRICE TRANSPARANCY, thuscompetition and lower prices.

However, price convergence has not occurred due to pricedifferentials being based on numerous factors.

2. Welfare gains from less uncertainty:

Due to increasing capital mobility, Governments wereincreasingly unable to control the volatile Exchange Rate.

It is evident that a risk averse individual will prefer a less

favourable exchange rate with certainty; for a firm it is moredifficult to ascertain (see the diagrams on next slide). The firmmay well prefer to be in a situation of fluctuating exchangerates, in order to exploit potential gains from exporting.

However, bubbles also increase the severity of exchange ratefluctuations the price level may drop well below the firmsMC curve putting it out of business,


9/14


(FIRMS PROFITS)

MC MC

Potential

Gain

Potential

Loss

P P

QQ

Stable profits

P

P

P


10/14


3. Lower real exchange rate

Real exchange rates include arisk premium component whichembodies the risk of default onGovernment debt. It alsoembodies the rental cost of

capital. Lower real interest rate will

buttress Investment, which willboost growth rates according tothe Solow (neoclassical) growthmodel.

The diagram to the side (from DeGrauwe) shows equilibrium; therr line has a slope equal to thediscount rate.

In a dynamic model, not only willa fall in the real exchange ratechange the slope of the line, but itmay also increase the productivityper worker, thus shifting the f(k)

curve upwards. Empirical evidence supports this

A

B

C

Y

k


11/14


4. Locks in the Central Bank to a credible

system

As shown by the Barro-Gordon Model; they can

no longer devalue the currency and thus cheat. 5. Acts as a source of further economic

integration, which increases trade and

competition.

6. If the Euro becomes a truly global

currency, There will be additional

Government revenues and a stronger

European financial industry.


12/14

A COST BENEFIT ANALYSIS

Whether or not one should indulge in acurrency union can be determined by thelevel of trade and the interaction of thecosts and benefits, as shown to the side.

The position of the Cost curve (andhence, the threshold level of trade) isdetermined by the viewpoint of the

economist whether one believes there isa sufficient level of wage/labourmarket flexibility.

The extremes are the monetaristviewpoint (top) and the Keynesianviewpoint (bottom).

The monetarist viewpoint has gainedtraction since the 1980s, although its

important to note that there is a widedifferential vis-a-vis the level ofopenness of different EU economies.

It is also important to state thecredibility bonuses associated withmonetary union thus even countrieswith LOW trade will have a case forjoining.

Costs/Benefits

Trade (% GDP)Costs

Costs

Benefits

Benefits

T1 T2


13/14

THE OCA LINE

The OCA line is a locus of points thatdistinguishes the combination ofsymmetry (i.e., sensitivity ofasymmetric shocks) and labour marketflexibility which is sufficient for agroup of countries to net benefit fromjoining a currency union.

The EU in aggregate does not comeanywhere close to the line, although itmay be argued (by De Grauwe) that acore group of EU member countriescan lie just above the line.

It is interesting to note that the USAlies on roughly the same latitude asthe EU (i.e., is subject to asymmetricshocks, as the 1933 crisis showed), but

is an OCA due to a much higherdegree of labour market flexibility.

It is anticipated that, over time, theEU will move in the direction of thearrow i.e., it will become moresymmetric and more flexible;especially if political union is everachieved.

OCA line

EU-25

Eurozone

USA

Labour Market

flexibility

Symmetry


14/14

DYNAMIC OCA

The three criterion for being an OCA are

integration, symmetry and Labour Market

flexibility; how has the EU evolved w.r.t these?

Integration: Existence of Euro has stimulatedtrade, suggesting integration is moving in the

right direction.

Symmetry: Unclear. Was moving in the right

direction until circa 2005, when the trend

reverses.

Labour Market Flexibility: Improvements in

the right direction.

optimal currency area theory

Documents