The Optimum Currency Area Theory
Instructions:
Optimum Currency Areas – Are they sustainable?-You may wish to focus on a specific region or country (eg. Australia, Europe, USA, ASEAN)
-Use at least 15 references for your findings Essential Sections:
Background
Sources of data/methodology
Findings
Conclusion
References
Appendix (if applicable)
Solution
The Optimum Currency Area Theory
A Valuation in the Context of the Eurozone Crisis
Background
The recent Eurozone crisis has uncovered the inadequacy of the economic and monetary unity (EMU) such as openness to imbalanced economic strains and failure to operate as expected by the principles governing operation in optimum currency areas (Bond, 2016). Since the introduction of the euro, intra-EU trade has improved however, lack of similar economic structures and the increased industrial specialization has caused unbalanced economies in the block. Eurozone has zero labor mobility and transfer payment system, this again limits the ability to adjust to the crisis involving economy and the monetary unity (Snaith, 2014). However, the proposed and already implemented measures have and will reduce the prevailing crisis and promote debt redemption, economic integration and improve fiscal discipline.
In 1999, 11 European nations decided to do away with their national currencies and join together to form the EMU (Ggertsson & Ferrero, 2016). The leaders had hope that with the usage of a common currency, the economic integration would be boosted among the members’ countries. It’s now more than ten years and the crisis rocking the Eurozone has put pressure on euro. These crises are the point of concern on whether the plan to have common currency over ambitious or well thought. The financial problem in 2007-2008 was economical disorienting to many countries in Eurozone, this exposed the underlying issues in the block and clearly depicted insufficient integration in the common currency (Fürrutter, 2012). The Eurozone crisis has brought more relevance to the theory of optimum currency area (OCA). OCA has the following properties (Pisani-Ferry, 2013)
- Factor mobility
- Financial market integration
- Economic openness
- Price and wage flexibility
- Fiscal integration
- Production diversity
- Similarity of inflation rate
The theory seeks to identify criterions to maximize benefits in the monetary union by reducing costs. This paper tries to investigate whether the proposed and implemented measures are sustainable to improve the Eurozone crisis
Methodology
The optimum currency area theory was established by Mundell and progressively other economists such as McKinnon and Kenen complemented the applicability of the theory (Mundell, 1961). At the core of the theory, it seeks to find ways and circumstances in which countries in a common currency block can benefit from the union. A country in currency union should balance the loss in national monetary policy against enhanced exports and stimulated aggregate demand of the common currency. During asymmetric economic shock, union’s central bank offers assistance to the member in order to recover but the victim country experiences an inflation (Snaith, 2014). Thus the mitigation measures of the common union bank come at the cost of other countries economic stability. An economic shock is asymmetrical when some countries in the currency union are hit by the shock whereas others are stable. The corrective response must be realized by changes in wage levels, the price of commodities, and monetary transfer payments and the imposition of labor mobility within the block (Polito & Wickens, 2014).
Criteria used in OCA
There are two groups of criteria used to evaluate the country’s ability to hold membership in the currency union. The first set of criteria involves reduction of exposure to the nations to unequal shocks (Issiaka & David, 2013). The second criteria involve measures by the block to adjust of the asymmetric shock in the member countries. Countries in common currencies are less exposed to asymmetrical shocks by having low levels of specialization, intraregional trade and having similar economic structures on the block. Policies which can be put in place to offset the unbalance economic shock in member countries include Transfer payments, homogeneous preferences, and factor mobility (Valeryevna, 2016).
Similarities in countries economic structure reduce the impact of the asymmetric shock in member countries. This is because the recession is comparable and almost even round the block. The reduction in the level of specialization in member countries of a block means that economic shock is small and almost even in the countries if they produce a variety of products (Maurice & Paul R, 2003). The intraregional trade boosts the economic integration and creates closer trade links within a momentary union. Openness criterion in common currency zones has less effect on the economy adjustment because variation in nominal value at the block level causes an automatic change in domestic prices of commodity thus the exchange rate stay unaffected.
Evaluation of Economic and Monetary Unit
Economist believes that the integration of the European nation to form a block was drive by the idea that political integration automatically brought increase welfare through economic integration. The supports of EMU believed that the use of common currency on the European continent would result in capital mobility and transnational labor flow which will in return boost economic integration (Handler, 2015). Despite this positive assumptions, pessimists like Karras and Matthes believed the EMU had disastrous consequence, it would further the economic divergences in the member countries, therefore, they criticized that introduction of euro was done prior to the establishment of the properties of the OCA. To establish the level of sustainability of the OCA the following factors in Eurozone will be considered, these are the basic properties of the OCA (Snaith, 2014).
- Similarity of economic structure in the Eurozone
The income level in Eurozone is unevenly distributed among the member countries. According to a report by Eurostat (2013), the rate of countries growth rate is relatively uneven and therefore there is an increasing difference in growth rate. In 2011, Greece had a growth rate of -7.11% while Estonia leads the block with a growth rate of 8.28% (Eurostat, 2017). The income gaps in among the member countries also varied widely in 2011. Slovakia had the average income of 65% while Finland posted 115%. In 2012, Spain had 24.4% unemployment rate while in Germany the level of unemployment reduced to 6.5% (European Commission, 2012). Spain and Greece had high levels of unemployed citizens due to the declining development in the countries after 2008 crisis.
- Openness trade
The openness of the Eurozone is reflected in its involvement in international trades, therefore, Countries with increase openness share economic activities. Report from World Bank (2011) indicated that small countries like Malta and Luxembourg are open to trade. Statistics from Eurostat (2013) show that intraregional trade increase between 1999 and 2011, however, the trade was previously high due to the single market program that was in 1992 (European Commission, 2012). These statistic show increase in integration after the Euro was introduced but again the increase was insignificant compared to the former state as trade increased by 8%.
- Specialization
According to Persson (Pisani-Ferry, 2013), after the introduction of the euro, EU countries had the moderate increase in industrial specialization. Between 1993 and 2008, the index of specialization increased from 0.39 to 0.43. The study concludes that industries in European nations became more specialized and some countries were more favored in the production of certain goods (World Bank, 2013). The specialization brought about less insensitivity to economic turbulences and therefore the Eurozone become more prone to asymmetric shocks.
- Factor mobility
Data from Eurostat indicate low migration level of European citizens (Eurostat, 2017). Europeans have low mobility and this continues to cause increased unemployment rate. High mobility within the block should counteract the asymmetric shocks. Studies have established Eurozone labor market is inflexible due to low labor mobility and market rigidity (Handler, 2015).
Finding
The evaluation of carried above shows that Eurozone does not depict the properties of the optimal currency area. There are underlying challenges bedeviling the block that need to be addressed. The difference in the economic performances and structures among the member countries show unsustainable OCA (Maurice & Paul R, 2003). It is clear that the common block brought increased specialization in the European nations a factor that exposes the countries to increased vulnerability to asymmetrical shocks. The EMU performance is restricted due to the differed approach to make the decision and manage crisis among the member states of the Eurozone (Pasimeni, 2012). Lack of the labor mobility which would cushion the block against asymmetrical shock further paralyzes the ability of the Eurozone to have sustainable OCA. Finding from the above properties makes it clear that OCA sustainability is a challenge in the Eurozone. However, the growth of economic harmonization and the boosted fiscal has been witnessed in the zone but the discrepancies are large across the countries which explain the prevailing lack of market unification in the Eurozone (Drobyshevsky, 2004). Hence, the sustainability of OCA in this block is questionable, the block is simply mixture a limited labor migration and fast capital migration with limited economic integration.
Conclusion
Although the share of intraregional trade has considerably increased in the Eurozone, the rising industrial specialization and lack of similarities in economic structures have caused a greater vulnerability to unbalanced economic shocks (Ggertsson & Ferrero, 2016). The established measures to stabilize the block include debt redemption and fiscal discipline. There are programs although limited such as EFSF which ideally is a transfer payment used to stabilize the block against asymmetric shock. Labor mobility in the region, however, appears to be a rigid and continual obstacle to the capability of EMU to adjust when the economy becomes unbalance in the Eurozone (Pasimeni, 2012). The economic integration in the region is still weak and needs some strategy to prevent future cost and make the EMU more unaffected to major economic disturbances. Efforts to mitigate the existing economic crisis will concurrently advance the EMU as a currency union.
References List
Bond, E., 2016. The euro-zone, Canada, and the optimum currency area theory. ATLIS, pp. 2-7.
Drobyshevsky, S., 2004. Problems Associated with Creation of a Single Currency Zone in the
CIS Countries, Moscow: Gaidar Institute for Economic Policy,.
European Commission, 2012. European Economic Forecast. European Economy, pp. 1-7.
Eurostat, 2017. External Trade Long-Term Indicators: Trade with EU. [Online]
Available at: http://epp.eurostat.cec.eu.int/portal/page?_pageid=0,1136217,0_45571467&_dad=portal&_schema=PORTA.
Fürrutter, M., 2012. The Eurozone. An Optimal Currency Area?, Innsbruck: IFIER .
Ggertsson, G. & Ferrero, A., 2016. Can structural reforms help Europe?. Journal of Monetary Economic, pp. 2-22.
Handler, H., 2015. The eurozone: piecemeal approach to an optimum currency area, Vienna: MPRA.
Issiaka, C. & David, G., 2013. Revisiting the theory of optimum currency area, s.l.: CEPII.
Maurice, O. & Paul R, K., 2003. International Economics. Boston: Pearson Education, Inc..
Mundell, R., 1961. A Theory of Optimum Currency Areas. American Economic Review, p. 657–665.
Mundell, R. A., 1961. A Theory of Optimum Currency Areas.. American Economic Review 51, p. 509.
Pasimeni, P., 2012. An Optimum Currency Crisis. The European Journal of Comparative Economics, pp. 173-204.
Pisani-Ferry, J., 2013. “The Known Unknowns and Unknown Unknowns of European Monetary Union. Journal of International Money and Finance, pp. 6-14.
Polito, V. & Wickens, M., 2014. How the Euro Crisis Evolved and How to Avoid Another: EMU, Fiscal Policy and Credit Ratings. Journal of Macroeconomics, pp. 364-379.
Snaith, H., 2014. Narratives of Optimum Currency Area Theory and Eurozone. s.l.:New Political Economy.
Valeryevna, D. Y., 2016. The Prospects of Creating an Optimum Currency Area among Asean Countries. Spatial Economics, pp. 81-98.
World Bank, 2013. The World Bank Database. [Online]
Available at: http://data.worldbank.org/