ECONOMICS OF THE EUROPEAN UNION

UNIT 10: OPTIMUM CURRENCY AREAS (OCA)

BOOK + slides (click on links) HIGHER WEIGHT IN THE EXAM

1. Introduction
Optimum Currency Area (OCA): A systematic way of trying to decide if whether it makes sense
for a group of countries to abandon their national currencies. (like an exam for countries)

- It’s a theory: Economic and political criteria that recognize that real economic costs of giving
up the exchange rate instrument arises in the presence of asymmetric shocks.

- Asymmetric shocks: Shocks that do not affect all currency union member countries. How do
OCAs react to asymmetric shocks?

- German reunification, natural disasters, European debt crisis, housing bubble, Covid – 19,
Ukraine conflict…

- Collapse of the Argentinian Peso in 2002.

- Common shocks can have asymmetric or symmetric effects on different economies.

Does Europe pass the tests? We don’t pass all the tests, although some questions very good

- Does it make good economic sense for each country to have its own currency? Yes in Europe
(reduction in transaction costs)

- Does the world need more than one currency? Yes

- No need of exchange money when travelling, exporting/importing…

- Currency transactions are risky as exchange rates fluctuate.

+ area size = more marginal cost and less marginal benefit

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2. Benefits of a currency area
1. Transaction costs (decline)

Elimination of transaction costs: The Commission claims: “if one started with one EU currency
and exchanged it successively in all the currencies of the EU before returning to the initial
currency… less than a 50% would be left”

2. Price transparency (increase)

Price comparability: goods prices become more directly comparable across countries.

- With no transaction costs and price transparency, there is more competition.

- Wage-setting:

Wages are set collectively ( Collective bargaining) either at the national or industry level.
(Doorn group: Entity ¨union of the unions¨ Luxembourg, France, Belgium…)

3. Uncertainty (decrease)

- Elimination of exchange rate risk.

- Foreign Direct Investment (FDI) is discouraged by fluctuations in exchange rates.

- Transfers of tech.

- Returns to scale.

- Better production structures and specialization.

4. Trade (increases)

- More competition + secure payments = more trade

- More choice for customers.

- More customers for successful producers.

- It is expected to cut prices of producers who enjoy some degree of monopoly on their home
countries.

5. Quality of monetary policy (there are both benefits and costs)

Monetary union implies a complete loss of national monetary policy autonomy.

- When a NCB lacks a tradition of effective policymaking VS the collective CB that does a better
job.

- More independent central bank.

- Monetary neutrality principle: printing money can be effective in the short run but negative
effects in the long run (rise in prices: Long-run VS short-run conflict).

- Transparency & accountability.

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3. Costs of a currency area
1. There is a loss of macroeconomic efficiency

- No exchange rate devaluation.

- Asymmetric shocks and stabilization policy (fiscal and monetary trap)

2. Specialization

- The higher the specialization, the higher the shock when there are crisis in the sector of the
specialization

4. The optimum currency area criteria

- 3 classic economic criteria:

1. Labor mobility (Mundell)

2. Production diversification (Kenen)

3. Openness (McKinnon)

Europe especially good in 2 and 3

- 3 political (and social) criteria:

4. Fiscal transfers

5. Homogeneous preferences

6. Solidarity VS. Nationalism

 Economic: 1. Labor mobility (Mundell) OCA are those within which people move
“easily”.

- If workers are highly mobile between two nations, those nations are more likely to form an
optimal currency area.

- Limitations:

Labor mobility is easier within national borders (culture, language, legislation, welfare system,
etc)

In presence of country specialization, skills also matter (human capital).

Capital mobility: difference between financial and physical capital.

Think about drawbacks of labor mobility in the case of Spain: high skilled move away, low
skilled stay in Spain (they require more payments) since these high skilled are young, older
people stay in Spain (more payments in pensions)

EUROPE DOESN’T PASS LABOR MOBILITY TEST (we move very little)

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  Economic: 2. Production diversification (Kenen)

- Countries whose production and exports are widely diversified and of similar structure form
an OCA.

- There are few asymmetric shocks and each of them is likely to be of small concern.

EUROPE PASSES THIS TEST

 Economic: 3. Openness (McKinnon)

- Traded goods prices are set worldwide;

- If all goods are traded, domestic good prices must be flexible and the exchange rate does not
matter for competitiveness.

- Limitation:

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 Exchange rate can affect profits for exporters (but nowadays most goods have little national
specificity).

EUROPE PASSES THIS TEST

 Political: 4. Fiscal transfers

- Countries that agree to compensate each other for adverse shocks form an optimum
currency area:

- Transfers can act as an insurance that mitigates the costs of an asymmetric shocks;

- Transfers exist within national borders;

Implicitly through the welfare system.

Explicitly in federal states as Germany.

- The debt crisis has brought forward the issue of transfers (i.e., moral hazard).

North-South relationship.

Shocks were consequences of high public debts, poor oversight of banks, some asset prices…

EUROPE DOESN’T PASS FISCAL TRANSFERS TEST BUT SOME STEPS HAVE BEEN TAKEN (SO
MAYBE IN THE FUTURE)

 Political: 5. Homogeneous preferences

- Currency union member countries must share a wide consensus on the way to deal with
shocks.

- Inflation: MS have rendered their own autonomous monetary policy.

Hawkish (Germany, Scandinavian Countries: low inflation rates) VS. Dovish.

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- Labor market.

- Deficits and debts.

EUROPE DOESN’T REALLY PASS HOMOGENEOUS PREFERENCES BECAUSE PREFERENCES ARE

NOT HOMOGENEOUS AMONG COUNTRIES. HOWEVER, WE HAVE COMMON INSTITUTIONS, SO
THE MORE POWER GIVEN TO THE EU CLOSER TO ACHIEVE HOMOGENEOUS PREFERENCES
(BUT STILL NOT REALLY PROBABLE)

 Political: 6. Solidarity VS. Nationalism

- When the common monetary policy gives rise to conflicts of national interests, the countries
that form a currency area need to accept the costs in the name of a common destiny:

- Countries that view themselves as sharing a common destiny better accept the costs of
operating an OCA.

- As it is unavoidable that there will be times when there will be disagreements and which may
follow national lines: people must accept that they will be living together and extend their
sense of solidarity to the whole union.

Nationalism example: Debt crisis in Greece: Nationalism when only rescuing German banks in
Greece. Covid and Ukrainian-Russian war example.

EUROPE NOT CLEAR IF IT PASSES OR NOT (BEFORE THE CRISIS ¨ALL FRIENDS¨, AFTER 2008
CRISIS MORE NATIONALISM… UNCERTAINTY FOR THE FUTURE. THIS CRITERIA IS THE ONE THAT
FLUCTUATES THE MOST)

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6. Is Europe becoming an optimum currency area?
1. Labor markets and mobility

2. Effects on trade and specialization

3. Fiscal transfers

4. Politics

Have we run so much in the OCA in Europe? Yes (especially in the 90s)

Why Norway has not joined? They don’t want to share the North Sea (oil and fisheries)

Why Sweden does not have the euro?

1. Quite stable

2. They don’t want to give up their monetary policy