Optimum Currency Areas

Professor Robert Mundell, 1999 Nobel Laureate: the father of the Theory of Optimum Currency Areas. Photo credit

Essentially the costs to a country of joining a single currency are related to loss of monetary policy; including the loss of controlling the exchange rate
Impact depends on whether the common currency area is optimal – i.e. it meets conditions that mean than the impact of asymmetric shocks is small

an asymmetric shock is a way of describing a recession which only affects some members of a group of trading countries
a highly integrated economy should be less susceptible to asymmetric shocks

If flexible then economy can return to equilibrium after a shock
If not flexible then a devaluation may be necessary (but this reduces credibility & is obviously not possible in an MU)
OR otherwise high unemployment is needed to bring wages back down to return to equilibrium

If mobile then shocks can be solved by labour moving to the high labour cost areas after a shock to bring down wages
EU labour is free to move between countries
If neither flexible wages nor labour mobility: Germany would actually suffer as the return to equilibrium could only occur if prices (& wages) rose in Germany

The use of a federal budget to reallocate funds and insure against the risk of an asymmetric shock (e.g. 40% replacement ratio with welfare payments by the federal government in the USA)
Without budget reallocation the country suffering the shock would have to run a budget deficit while the country benefiting or unaffected would be running a budgetary surplus
Increased government borrowing by the French would raise real interest rates, FFr appreciates, France less competitive

Currency of country suffering shock could devalue in order to artificially increase competitiveness, but this reduces credibility / causes instability
This is the only solution lost with a single currency, the other solutions would have to be improved with a single currency to accommodate this
its effectiveness is defined by expectations - after a currency is devalued the its credibility in the market place is reduced as expectations are changed
the real exchange rate takes into account expectations thereby eliminating the benefit of subsequent devaluations
Devaluation on its own does not solve the structural adjustment process

Closely integrated European economy is less susceptible to asymmetric shocks, and will become less so in future with the effects of the single currency increasing integration
But Fiscal policy will still differ between states and by definition these will be shocks confined to one state
Differing wage bargaining between nations could cause a shock

(unemployment vs. inflation)
countries differ in their preferred position on the Phillips curve, wet like Italy or hard nosed like Germany
on entering a single currency inflation falls in Italy & rises in Germany as they both move to the common inflation rate (in theory)
new monetarist theory says that the Phillips curves is not stationary and moves with expectations of inflation, the LR Phillips curve is vertical, so that inflation can be at any level relative to the natural unemployment rate (which is thus independent of inflation) so there is no loss in joining a monetary union unemployment is independent of inflation, so Italy having to adopt a lower inflation will not mean unemployment rises in the LR
high inflation would have to be reduced by Italy at some point anyway, so this is not a cost specific to joining an MU – in fact the MU may increase credibility of the policy & thus reduce the costs of reducing inflation

In the LR the unemployment rate would revert to the NAIRU, from which the LR vertical Phillip’s curve is given

high inflation countries such as Italy benefit from a single currency containing low inflation countries such as Germany as the inflation rate for the single currency area as a whole falls to that of Germany
this is due to the high credibility of the German Bundesbank which is respected by the currency markets

Italy’s productivity growth may still be lower than Germany’s after the MU, a problem if wage bargaining is centralised & the same increases in wages are demanded in both countries – Italian industry would become increasingly uncompetitive – this is the crucial aspect
Returns on investment in the lower productivity countries will be higher, so acting as a stimulus to greater investment and therefore more equal productivity growth

if trade unions are completely decentralised or centralised there are problems, but somewhere in between is OK

fast growing countries will not be restrained by MU?
Fast growing countries have fast growing imports (i.e. trade deficits) – which theoretically could have been solved with a devaluation of the currency – not possible in a MU
This theory is not likely – fast growing countries see an appreciation of their currencies
Growth attracts capital flows which finance the current account deficit without need for devaluation – MU can only aid this capital inflow

primary deficit + interest payments on debt = new debt + money supply
government can use inflation as a form of tax in order to raise revenue – if the country’s taxation system in undeveloped this can be a cheaper method than imposing new taxes – Mediterranean countries have used this method in the past

Seigniorage represents a significant amount of income for currency issuers, the Financial Times estimates it as €13bn
Before EMU, Germany was the main beneficiary due to the use of the Deutschmark in eastern Europe and Russia; now the Seigniorage will be divided amount the members states according to GDP and population

Page last modified March 2002.
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