Is the Eurozone an Optimal Currency Area?

Abstract

The purpose of this paper is to determine if the Euro zone is an optimal currency area. It involves inspecting existing related literature and data for certain prerequisites set out by the Optimum Currency Area theory. The outcome is that the Euro zone is not an optimal currency area, despite major improvements seen following the introduction of the Euro in the areas including …. etc . Meanwhile, the prerequisites of ….. etc are not met.

Introduction

In 1979, the European Commission established the European Monetary System (EMS) arrangement, involving a large number of countries who were part of the European Economic Community (EEC) fixing their exchange rates based on a unity known as the European Currency Unit (ECU). Following this event, discussions over the possibility of the Euro zone being an Optimal Currency Area emerged. In January 1999, the European Union introduced the Euro as it’s common currency, the Euro. Initially, the euro served its purpose as an electronic currency utilised by banks. In January 2002, the Euro was introduced as banknotes and utilised as a legal tender for all transactions in 12 countries including Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

The rest of the dissertation is structured in the following format.

Section II includes a description of the theory of Optimum Currency Area which was the workings of Robert Mundell in the early 1960s. In Section III covers related literature on the subject as well as empirical

Related Literature

This section includes a review of the related literature on the Optimum Currency Area theory.

Mundell (1961) published his work on the theory of optimum currency areas, which focused geographical regions that was that would benefit from a single monetary policy under a common currency or definitely pegged exchange rates. This was to counter Friedman (1953)’s argument that strictly flexible exchange rates enabled corrective changes required to bring about external equilibrium.

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In order to determine whether a geographical region was an optimal currency area, Mundell (1961) studied the mobility of factors, in particular labour, as the main perquisite. In an currency which has the characteristics of high mobility of labour and other factors products, there is a high probability that the need for altering the real factor prices is likely to be lower. High Labour mobility implies that workers have the flexibility of moving to different counties, which have more desirable demand conditions in order to reduce unemployment in their home country. Meanwhile, wage flexibility implies that an adjustment in the real exchange rate in the event of asymmetric shock can come about from wage adjustments as wages are the most important component of costs, therefore prices.

Later on, several other factors were taken into consideration. McKinnon (1963) argued that the more a country is in involved in international trade, the benefits it is likely to experience, here depreciation would have lesser effect in rebalancing a country’s external deficit. Kenen (1969) debated that a well diversified economy was a criteria of optimum currency area perquisites. In this case, the economy can adjust relatively well by absorbing sector-specific shocks thought shifting production within the internal economy. Meanwhile, Fleming (1971) believed that similarity of inflation rates should be a one of the perquisites to determine an OCA region as this will help maintain balanced current -accounts in other counters in the monetary union.

During the 1990s, future of European single currency was the hot debate (Tavlas, 1994). (Bayoumi and Eichengreen, 1993a) find that asymmetrical shocks was more conspicuous in Europe when compared to states in US, but there was findings of smaller and more correlated shocks between

The benefits of a common currency are all microeconomic in nature relate to lower transaction costs, more transparency and less risk.

The costs of a common currency are all macroeconomic n nature and relate to the loss of independent monetary policy andd exchange rate adjustment in the face of asymmetric shocks.

Price & Wage Flexibility:

• Consider the EMU and suppose Italy is hit by an asymmetric shock increasing
• unemployment in Italy but nowhere else. Adjustment must come through relative prices in
• the member countries such that Italy becomes more competitive and unemployment
• decreases. Because the exchange rate is fixed, adjustment has to take place in goods prices.

Wage exibility:

• Since wages are the most important component of costs (and thus prices), an adjustment
• in the real exchange rate can come about through wage adjustments. Flexibility in wages
• are thus desirable for a common currency.
• mobility of factors of production including Labour

Fiscal Integration: If the currency union meet the criteria of imposing fiscal transfer system, the need to alter exchange rate caused by asymmetric shocks is significantly reduced due the fiscal transfer system aiding the country affected by the shock.

Trade openness: In open economies, the exchange rate as policy instrument is not very effective for adjusting shocks, especially in small open countries where total consumption of goods and services is made up of large component of imported goods and services from other countries.

Diversification in production and consumption

Before the European Union founded it’s monetary area with common currency, questions such as whether the eurozone can be classed as a optimum currency area and whether the judgement to consolidate the European Union member states under common currency was in fact the correct decision.

Benefits of a common currency

One of benefit of a common currency is the elimination of transaction costs, this removes the deadweight loss to society.

Another benefit is increased price transparency. Prices can be compared more easily across countries which shoulder foster competition and reduce price differences between countries.

Another benefit is reduced uncertainty, removing uncertainty about future exchange rates leads to welfare gains.

International Currency, join currency may play more important role in the global econoy, Better funding and more liquid.

Costs of common Currency

The main costs associated with a common currency is that member countries are more likely to suffer from asymmetric shocks. Suppose that a country gets hit by a shock that increases unemployment in that country but does not affect the other member countries, in a currency union, the country cannot devalue its exchange rate to dvalue its exchange rate to join competitiveness because the exchange rate is fixed. In addition, the country cannot relax its monetarypolicy to boost economiy because monetary policy is no longer independent,. Hence the ability to deal amcroeconomics shocks is greatly limited for inidividual countries. Adjustment must come throuh other channels which define a “optimal currency area”.

The Theory of Optimal Currency Area

The theory of Optimal Currency Area was introduced by Robert Mundell in 1961.

Related Literature & Empirical Evidence

Robert Mundell (1961) popularised topic of Optimum Currency Area to apply to the a geographic region that potentially could benefit from one monetary policy in a common currency or pegged interest rate.

More specifically, Muindell (1961) looked into the mobility of factors, paying extra attention to labour. Geographic labour mobility enabled several factors. In the next few years, new factors were taken under consideration. McKinno (1963)

Kenen (1969) argued that monetary unions would better suit countries with diversified economies, as demand or supply shocks that affected one sector could be more easily compensated by the others.

Moreover, financial integration would also help mitigate asymmetrical shocks by directing savings from surplus regions to affected ones (Ingram, 1962).

Otherwise, Fleming (1971) considered that a monetary union required, above all, a similarity of inflation rates, to maintain balanced current-accounts in the different member states. Otherwise, differences of competitiveness would progressively arise, with countries with higher inflation running persistent deficits.

Trade Openness

In terms of trade openness, studies have been undertaken to analyse the effect of common currency union in the Europe on the intra-European trade. Rose and Van Wincoop (2001) estimated a 50% expansion in intra-euro-area trade. Meanwhile, Bun and Klaassen (2002) computed similar results, estimating an rise of approximately 40% over time.

Openness ratio, which is expressed as a percentage is used to measure the extent which a country is involved in international trade. (Bayoumi and Eichengreen, 1997) suggests using the following formula to compute the ratio:

Referring to Figure 1, year 2009 ratios are considered exceptions due to the global economic crisis causing decrease in international trade (IMF, 2010). Most of the countries seem to have experienced a rise in their openness ratio between 1999 and 2008. Furthermore, Luxembourg, Netherlands, Germany and Finland saw significant rises in their openness ratio, meanwhile Italy, Greece and Ireland only saw minor increases. This suggests that there was an uneven benefits experienced from the single currency, potentially changes in international competitiveness of each country.

A benefit of common currency union is that it leads to elimination of exchange rates risk and transaction costs inside the euro area (Emerson et al. 1992). Once again, we use the openness rate to measure this, however this time only country’s imports and exports to and from other countries who are members of the Economic & Monetary Union. The formula is the following:

Ignoring 2009 (see explanation above), Figure 2 displays majority of countries failing to experience a rise in their intra-EMU ratios. On the other hand, Belgium, Luxembourg, Netherlands, Austria and Germany, meanwhile Spain, Ireland and Greece saw major contractions in their ratios. This could be due the loss of competitiveness in named countries in relation to other EMU countries.

Production Diversification

(Kenen, 1969) argues that that have diversified production of goods and servers are likely to benefit more from a common currency union due other sectors compensating for sectors which are hit by shocks. We measure this by inspecting the exports of countries in the EMU based on sector as a share of its total exports in the EMU. The formula is given by.

Conclusion

In this study, it is determined whether the Euro zone is an optimal currency area. This statement implies that the welfare benefits of the member states of the European has increased after the monetary union consolidation under the common currency, the Euro. For this, factors such as Price & Wage Flexibility, Mobility of factors of production including Labour, Fiscal Integration, Trade Openness, Diversification in production and consumption is investigated to measure the degree of optimality of the currency area.

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.

Overall, it is safe to conclude that the Euro zone is not an optimal currency area. The Economic & Monetary Union must consider taking action in many areas to ensure that the Euro zone satisfies the prerequisites laid out by the Optimal Currency Area theory in order to be classed as a optimal currency area.

References

Bayoumi, T. and Eichengreen, B. (1997), “Ever closer to heaven? An optimum-currency-area index for European countries”, European Economic Review, 41(3-5): 761–770.

Bun, M. and Klaassen, F. (2002) Has the Euro Increased Trade? Tinbergen Institute Discussion Paper

TI, 108(2).

Frankel, J. and Rose, A. (1997) Is EMU more justifiable ex post than ex ante. European Economic

Review, 41, p.753-760.