Is the Euro Zone an Optimal

Currency Area?

Marjan Petreski, MSc

Ministry of Finance
Macroeconomic Policy Department
Macroeconomic Modeling and Projections Division
Junior associate

Euro College – University Studies in Kumanovo

Business Administration and Economics Department
Lecturer in International finance, Monetary policy and banking

March, 2007

Abstract

The aim of this paper is to assess whether the Euro zone is an optimal currency area. The
judgement is made on the basis of the existing literature and available data for several criteria as a part
of the OCA Theory. The ultimate conclusion is that the Euro zone is not an optimal currency area, albeit
significant advancements towards it were made past the introduction of the euro, in terms of inflation
convergence, financial integration and intra-trade intensification. Yet, the criteria of labour mobility,
wage flexibility, fiscal and political integration are far from being satisfied.

Electronic copy available at: http://ssrn.com/abstract=986483

 Contents

INTRODUCTION ..................................................................................................................................... 2
THE THEORY FOR THE OPTIMAL CURRENCY AREA........................................................................ 2
IS THE EURO ZONE AN OPTIMAL CURRENCY AREA: PREVIOUS STUDIES AND SOME RECENT
EMPIRICAL FACTS ................................................................................................................................ 5
CONCLUSIONS .................................................................................................................................... 13
REFERENCES ...................................................................................................................................... 14

Marjan Petreski 1

Electronic copy available at: http://ssrn.com/abstract=986483

 Introduction

After the launch of the European Monetary System in 1979, when the majority of the currencies

of the then European Community fixed their exchange rates around the central parity known as a

European Currency Unit (ECU) a debate arose as to the question whether Europe is an Optimal

Currency Area. The debate gained on hotness especially behind the introduction of the Euro as of

January, 1st 1999, when the then Member States participating in the Exchange Rate Mechanism (ERM

I) altered their national currencies into the common European currency. In other words, what has been

frequently questioned in the preceding couple of years is whether the Euro zone countries are better off

with a common currency as compared to the option of retaining the national currency. The latter

simplified notion lies in the substance of the Theory for the Optimum Currency Areas.

This paper is an attempt to link the theoretical backgrounds of the OCA Theory with the

practice of the Euro zone. For that purpose, the remainder of the paper goes as follows. The next part

briefly describes the Theory of OCA which emerged from the pioneering work of Robert Mundell in the

1960’s, laying down the criteria for becoming and OCA. The second part discovers some earlier works

on the topic, along with an empirical assessment of whether the Euro zone is an optimal currency area.

Finally, the last part concludes the paper.

The Theory for the Optimal Currency Area

The Theory of the Optimum Currency Area appeared in the early 1960’s as a result of the

seminal work of Mundell (1961), along the subsequent work of McKinnon (1963) and Kenen (1969). To

start with, Mongelli (2002) defines the currency area as an optimal geographic domain of a single

currency, or of several currencies, whose exchange rates are irrevocably fixed and might be unified.

Moreover, in the latter case, the common external value is determined on the foreign exchange market

freed from an official monetary intervention (Grubel, 1970). The optimality in the context of the currency

Marjan Petreski 2
areas refers to several properties of the currency areas which result in an improved welfare of the

population resident within the area above the level enjoyed when each territory was a separate

monetary entity (i.e. possessed its own monetary unit). To be precise, these OCA properties embrace

the following:

Mobility of labour and other factors of production; In a currency area satisfying this

characteristic, it is likely that there will be less need for altering the real factor prices (Mundel,

1961). It is acknowledged that the factors mobility results in their most efficient allocation even

within a free trade area or customs union, enhancing the welfare of the area. Moreover, in a

currency area, the mobility of the capital is determined by the speed by which investment is

being supplied by one country and absorbed by another. Whereas the labour mobility is usually

higher in the medium to long run, in that manner easing the adjustment to the permanent

shocks hitting the countries.

Price and wage flexibility; This is essentially important for a currency area in a short run,

when an adjustment process entails itself as a necessity, in order to absorb a shock in the

economy. In that sense, if prices and wages in a currency union are flexible, the adjustment

process will not end up with sustained unemployment in one country and inflation in the other.

In turn, this will lessen the call for an exchange rate changes. Then again, if prices and wages

are rather rigid, flexibility could be achieved through the mechanism of the exchange rate.

Financial market integration; In a currency union, we usually speak about one unified

financial market. Financially integrated countries in a currency union trim down the need for an

exchange rate adjustment. In these countries only a small change in the interest rates will lead

to capital movements across the countries until the equilibrium is again settled.

Marjan Petreski 3

Economic openness; The higher the openness, the faster the international prices transmit on

the domestic monetary scene. Thus, the exchange rate becomes less useful in the adjustment

process.

Diversification in production and consumption; The higher the diversification, the lower the

need for changes in the terms of trade through the nominal exchange rates. In other words,

diversification acts as an absorber of shocks.

Similarity in inflation rates; It is expected that in a currency union, countries possess similar

or close inflation rates. Fleming (1971, cited in Mongelli, 2002) argues that when inflation rates

of the countries in a monetary union converge, terms of trade will also converge. In turn, this

diminishes the need for exchange rate adjustment because of the equilibrated current account

transactions.

Fiscal integration; If the monetary integration is followed by an integration of the fiscal transfer

system, than the latter will reduce the need for exchange rate adjustment behind a shock since

the fiscal integration will lend a hand to the region or country hit by shock.

Political integration; Finally, political will for adopting a single currency is the crucial one in the

whole story. Haberler (1970) stresses that the political will encompasses commitment to joint

economic policies, common fiscal policy and a strong institutional linkage. Tower and Willet

(1976) add that “a successful currency area needs a reasonable degree of compatibility in

preferences toward growth, inflation and unemployment and significant ability by policy-makers

in trading-off between objectives.” (p.10).

Currency area that satisfies these criteria becomes an optimal currency area. The optimality

stemming from the fulfilment of these characteristics of the currency zones finished up with a process of

welfare creation which means that the benefits form the monetary unification exceed the costs.

Marjan Petreski 4
 Is the Euro zone an Optimal Currency Area: Previous studies and some

recent empirical facts

Plenty of studies are devoted to the task to acknowledge whether a concrete monetary

unification leaded to the accomplishment of the optimality clauses for a currency area. These studies

usually refer to the case when a country fixes its exchange rate to that of its major trading partner, in

that manner creating a currency area. In this case, the exploration of the optimality issue usually refers

to the fixing country. However, a real research challenge emerges when the monetary unification is

crowned by an introduction of a common currency, as was the latter case in the world, the introduction

of the euro.

As mentioned above, monetary unification in terms of the OCA Theory in Europe started in

1979 with the creation of the EMS, when the then member states of the then EC, irrevocably fixed the

exchange rates of their currencies to the central parity represented through the imaginary European

currency, the ECU. The notion behind this became known as the Exchange Rate Mechanism I. Yet, 20

years were needed these initial steps for monetary integration to be followed by a single currency

adoption. Albeit some attempts to judge the EMS as an OCA were made, the real challenge was posed

beyond 1999. Namely, the start of the EMU boosted the interest for the debate whether sharing a new

single currency sets free forces that bring Euro area countries closer together (De Grauwe and

Mongelli, 2005).

Mongelli (2002), at an outset, vastly explores the OCA Theory, devoting significant share to the

Euro zone. Although the study is conducted rather early, some important conclusions are drawn. For

instance, he elucidates the inference that the labour mobility, as well price and wage flexibility across

European countries are low. Supportive to this is the report of the EU Commission (2004), which finds

this flexibility to be hampered by the slow completition of the Single market and by the slowness of

dismantling some non-tariff barriers. Also real wages are quite rigid in the majority of countries; labour

Marjan Petreski 5
mobility is low and usually motivated by other factors and not as a response to an economic shock

(OECD, 1999).

Supportive to these notions are the facts presented on the next graphs. The first one grasps

the figures for the foreigners in the Euro area countries. Although a good part of the figures is missing,

those presented for the period 1999-2005 show no changes, which indicates the slow labour mobility.

On the second graph, an attempt to estimate the labour market responses to an asymmetric shock is

made. It is visible that the labour market responds slowly to such shocks. The latter facts do not support

the notion that the Euro zone is an OCA.

Foreign population in Euro zone countries

8000000
7000000 1999
6000000 2000
5000000 2001
4000000 2002
3000000 2003
2000000 2004
1000000 2005
0
xe taly
B e ia

Sl al
d

d
Gr y

Po s
Ge ce

ain
um

Ne ourg

ia
ce
an

nd
lan

lan
str

g
en
an

ee

rtu

Sp
lg i

I
rm

rla
Au

F in

Ire

ov
mb
Fr

the
Lu

Source: Eurostat

Marjan Petreski 6
 Source: OECD, 1999

Contrary to the voice of the above discussion, several studies found strengthening of the

relevance of the foreign direct investment flows in the Euro area, which is a support for the OCA. For

instance, OECD (1999) shows that both inward and outward FDI’s from the Euro area countries raised

in almost all countries behind the introduction of the Euro. Yet, broadly speaking for the overall financial

integration in the Euro zone, it is rather lower as compared to that in the US (Krugman and Obstfeld,

2003). Still, Issing (2000, cited in De Grauwe and Mongelli, 2005) observes an increasing degree of

financial markets integration in terms of fewer opportunities for arbitrage and smaller interest rates

differentials. Moreover, the money market is being integrated first right after the introduction of the

Euro, while the yield differentials among the euro area government bonds markedly converged.

Mongelli (2002) further stresses the high economic openness of all European countries as well

the high diversification in production. Not only the trade intensified beyond the intro of the Euro, but also

countries that will join the Euro area in future will satisfy the properties no matter whether they built

OCA with the Euro zone before (Frankel and Rose, 1997). In addition, inflation differentials narrowed

down in the Euro area countries (EMI, 1998). On the fiscal plan, he explains that all Euro area countries

matched the fiscal Maastricht criteria and now comply with the Stability and Growth Pact. However,

federal transfers and changes in federal tax payments provide a much bigger cushion for region-

specific shocks in the U.S. than do EU revenues and expenditures (Krugman and Obstfeld, 2003).

Marjan Petreski 7
Moreover, there are no such fiscal transfers within the EU, at all. The EU budget is very small, only 2%

of the GDP of EU.

In the context of the economic openness, several studies tested the effect of the monetary

unification in Europe on the intra-european trade. Two of them are worth mentioning, i.e. that of Rose

and Van Wincoop (2001) who predicted an increase of the intra-euro-area trade of more than 50%.

Similar results stem from Bun and Klaassen (2002) who use a dynamic panel model and estimate a

long run effect of about 40%.

On the next graph, I present the share of intra-euro-zone-trade (exports-plus-imports) from the

GDP of the Euro zone countries. It can be inferred that there is an effect of the monetary unification on

trade, although it is not ample. Namely the intra trade before the introduction of the Euro in 1998

accounted to 41,1% of GDP of the Euro zone countries, whereas this percentage is 54,6% in 2006,

which corresponds to an increase of 13,5 percentage points or 33%. Albeit the previously mentioned

studies expected higher increase, still this figure provides support for the Euro zone as an optimal

currency area.

Total intra trade (% of Euro area GDP)

60,0

50,0

40,0

30,0

20,0

10,0

0,0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: European Economy, 2006

Marjan Petreski 8
 In the study of De Grauwe and Mongelli (2005) an attempt for overall assessment of whether

the Euro zone is an optimal currency area is pursued. They conclude that in the first two years, HICP

inflation significantly converged, although the convergence started even before the introduction of the

euro. Domestically the adoption of the euro has been associated with an extended period of price

stability: the low level of inflation and inflationary expectations testify to the credibility of the common

monetary policy (European Economy, 2006). Additionally, Beck and Weber (2001) found considerable

turndown in the cross border volatility of the relative prices among Euro countries.

Source: Eurostat

Marjan Petreski 9
 On the preceding graph, I present the inflation indices for the EMU countries (which as of 1

January 2007 are 13, after Slovenia has joined). It can be inferred that the huge inflation discrepancies

during the 1990’s converged right behind the introduction of the Euro in 1999. The convergence is even

reinvigorated in the last period, i.e. the period from 2004 onwards.

Finally, De Grauwe and Mongelli (2005) agree that financial integration was spurred, especially

in the money market segment, which has been integrated almost immediately; deposit market has been

also integrated, while significant advancement has been made on the bond market. I will try to assess

again these notions of De Grauwe and Mongelli (2005), by looking at some indicators of the financial

integration in the Euro zone.

On the next graph, I look at two indicators for the money and bond market. It is inferable that

standard deviations for both overnight lending rates and government bond yield spreads sharply

decreased immediately behind the introduction of the euro. This points to a strong support for the

notion that the Euro zone is financially integrated and, therefore, a support for OCA Theory in respect to

the Euro zone.

Money and bond market indicators

200,00
180,00
160,00 Cross-country standard deviation
140,00 of the average overnight lending
120,00
Indexes

rates
100,00
80,00 Standard deviation of government
60,00 bond
40,00 yield spreads for 2- year maturity
20,00
0,00
1997-01
1997-10
1998-07
1999-04
2000-01
2000-10
2001-07
2002-04
2003-01
2003-10
2004-07
2005-04
2006-01

Source: Eurostat

Marjan Petreski 10
 In the same line of reasoning, the share of MFI cross-border holdings of debt securities issued

by euro area and EU non-MFIs, also increased after the threshold. Finally, looking at the dispersion of

the number of bank branches and subsidiaries and their total assets across Euro area countries, again

the conclusion is in favour of the spurred financial integration of the Euro zone.

Share of MFI cross-border holdings of debt securities

issued by euro area and EU non-MFIs (% )

0,45
0,4
0,35
0,3
0,25
0,2
0,15
0,1
0,05
0
1998-01
1998-03
1999-01
1999-03
2000-01
2000-03
2001-01
2001-03
2002-01
2002-03

2003-01
2003-03
2004-01
2004-03

2005-01
2005-03
Dispersion accroess Euro area countries 2006-01

6 Number of euro
5 area bank branches (% )
Number of euro
4 area bank subsidiaries (% )
3 Total assets of euro
area bank branches (% )
2 Total assets of euro
1 area bank subsidiaries (% )

0
2001 2002 2003 2004 2005

Source: Eurostat

All in all, significant changes seen through the prism of the OCA properties have been made in

Europe right after the introduction of the Euro. However, early studies conclude that the Euro zone is

Marjan Petreski 11
not an optimal currency area. A significant question is weather the Euro zone is heading towards an

optimal currency area. The presentation of the recent empirical facts, however, points out to some

indicators which provide affirmative support for this question.

The next table tries to summarise the topic explored above:

Criterion Satisfied?
Labor mobility no
Price and wage flexibility no
Financial market integration yes
Trade openness yes
Diversification in production yes
Similarity in inflation rates yes
Fiscal integration no
Political integration no

According to the table, half of the criteria are fulfilled. However, those that are not, are those

which are more significant, among which, the political integration and the common fiscal policy. The

former is in the basis of the EU Constitution Draft, which for the time being is dead, whereas the latter is

probably a distant future.

All in all, although significant changes in terms of the optimality issue for the Euro zone as a

currency area have been made, the Euro zone could not be considered as an optimal currency area.

Yet, since the introduction of the euro, significant advancement followed in the area of financial

integration, inflation convergence and the trade openness. On the contrary, labour mobility and wage

flexibility remained low, while the fiscal integration is downed to respecting the SGP rules and not to a

common fiscal policy which will enable the fiscal transfers to act as an absorber of external shocks.

Marjan Petreski 12
 Conclusions

The question that has been addressed in this paper was whether the Euro zone is an optimal

currency area, i.e. whether the welfare of the countries participating in the EMU increased after their

monetary unification under a common currency, that is the euro. In that sense, several factors are

under consideration when measuring the optimality of the currency area: labour mobility and wage

flexibility, financial integration, inflation convergence, trade intensification, fiscal and political integration.

The exploration of the topic ranged from citing what previous studies found to empirical

assessment of recent economic data for the Euro zone. The conclusion sheds light on the notion that

significant advancement has been made on the inflation convergence, which has been strengthened

especially in the last years, financial integration, mainly measured through the money market and bond

market indications, and in an extent, the trade intensification among Euro area countries, which

intensified by about one third. At the same time the production is well diversified.

On the other hand, labour mobility is low, wages are rigid, whereas on the field of fiscal

integration is done almost nothing. The fiscal policy is still a national policy and not a common one.

Political integration is still questioned as the CT is stuck in the approval process.

By all accounts, the Euro zone is not an optimal currency area. Efforts are needed on many

fronts in order optimality to be achieved for every OCA criterion and in that sense the Euro zone to

become an optimal currency area.

Marjan Petreski 13
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Marjan Petreski 14
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Marjan Petreski 15