EUROPEAN ECONOMICS:

OPTIMAL CURRENCY AREA

THEORY
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)
WAGE FLEXIBILITY Wage Demands
 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 union and will thus
lower wage demands to
ensure maximum coverage.
Number of Unions
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 important to 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.
FISCAL FEDERALISM
 Highly politically sensitive issue.
 The fear is that there will be an extension of the mezzogiorno
problem; in Italy there is a system of transfers from the
productive and prosperous North to the less prosperous South.
 They have acted in such a way as to reduce incentives for
labour mobility, thus creating a system of dependency.
 Problem has become such that there have emerged parties
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 of Fiscal
federalism is about the same as the impact of Automatic
Stabilisers; thus, it is desirable to not choke Auto. Stab.
EXCHANGE RATE FLEXIBILITY
 THREE problems with changing
Exchange Rates. Price LRAS
 1) Competitive devaluations are
frowned upon due to the ‘beggar-thy-
neighbour’ aspect to them.
SRAS’
 2) They may not have a long-run
impact due to real wage resistance.
After a devaluation, imports become
more expensive and SRAS shifts back
up as workers demand higher wages. SRAS
Thus, another devaluation is needed,
and the vicious cycle repeats itself,
leading to ever higher inflation.
AD’
 However, this degree of pass through
depends on the relative importance of
import markets in the economy.
 3) Devaluations do not tackle the cause AD
of the shock.
 In addition, depends on the degree of
openness.
LIKELIHOOD OF ASYMMETRIC
SHOCKS European
Symmetry Commission
 Two views: European Commission and
Krugman
 EC view: As integration increases, so will
symmetry (i.e., top diagram)
 Krugman view: As integration increases,
industries will tend to collate in specific
regions due to geographical external
economies of scale. Thus any industry
specific shock will turn into a country-
specific shock.
 Two views shown in the diagrams.
 The EC is the prevalent argument; as
integration increases, state boarders
become less important in constraining
activity, so industrial areas may straddle
numerous states.
 In addition, there is a rising importance of
Krugman
services relative to manufactures, dulling
the Krugman argument.
 Finally, empirical evidence indicates an
upward sloping curve. Integration
BENEFITS OF A COMMON CURRENCY
 1. Removal of Transaction Costs:
 This is a Pareto Improvement (the loss imposed by transaction costs are
a deadweight loss).
 Should also lead to increased PRICE TRANSPARANCY, thus
competition and lower prices.
 However, price convergence has not occurred due to price differentials
being based on numerous factors.
 2. Welfare gains from less uncertainty:
 Due to increasing capital mobility, Governments were increasingly
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 more difficult to ascertain
(see the diagrams on next slide). The firm may well prefer to be in a
situation of fluctuating exchange rates, in order to exploit potential gains
from exporting.
 However, bubbles also increase the severity of exchange rate
fluctuations – the price level may drop well below the firm’s MC curve
putting it out of business,
 BENEFITS OF A COMMON CURRENCY
(FIRM’S PROFITS)

P P

Potential
MC MC Gain
P’’’
P’

P’’

Potential
Stable profits Loss

Q Q
BENEFITS OF A COMMON CURRENCY
 3. Lower real exchange rate Y
 Real exchange rates include a ‘risk
premium’ component which embodies
the risk of default on Government debt. C
It also embodies the rental cost of
capital.
 Lower real interest rate will buttress
Investment, which will boost growth
rates according to the Solow B
(neoclassical) growth model.
 The diagram to the side (from De
Grauwe) shows equilibrium; the rr line
has a slope equal to the discount rate.
 In a dynamic model, not only will a fall A
in the real exchange rate change the
slope of the line, but it may also
increase the productivity per worker,
thus shifting the f(k) curve upwards. k
 Empirical evidence supports this
hypothesis.
BENEFITS OF A COMMON CURRENCY
 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.
A COST BENEFIT ANALYSIS
Costs/Benefits Benefits
 Whether or not one should indulge in a
currency union can be determined by the level
of trade and the interaction of the costs and
benefits, as shown to the side.
 The position of the Cost curve (and hence, the
threshold level of trade) is determined by the
viewpoint of the economist – whether one
believes there is a sufficient level of
wage/labour market flexibility.
 The extremes are the monetarist viewpoint Costs
(top) and the Keynesian viewpoint (bottom). Trade (% GDP)
 The monetarist viewpoint has gained traction
since the 1980’s, although it’s important to note
that there is a wide differential vis-a-vis the Benefits
level of ‘openness’ of different EU economies.
 It is also important to state the credibility
bonuses associated with monetary union – thus
even countries with LOW trade will have a case
for joining.

Costs

T1 T2
 Symmetry
THE OCA LINE
 The OCA line is a locus of points that
distinguishes the combination of symmetry OCA line
(i.e., sensitivity of asymmetric shocks) and
labour market flexibility which is sufficient
for a group of countries to net benefit from Eurozone
joining a currency union.
 The EU in aggregate does not come
anywhere close to the line, although it may
be argued (by De Grauwe) that a ‘core’
group of EU member countries can lie just
above the line.
 It is interesting to note that the USA lies on
USA
roughly the same latitude as the EU (i.e., is
subject to asymmetric shocks, as the 1933
crisis showed), but is an OCA due to a much
higher degree of labour market flexibility.
 It is anticipated that, over time, the EU will EU-25
move in the direction of the arrow – i.e., it
will become more symmetric and more
flexible; especially if political union is ever Labour Market
achieved. flexibility
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 stimulated trade,
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.