A critique of the theory of

Optimum Currency Areas

European Integration

Prepared by Md.Khurshed Alam

International Business-EI
30.11.2010

Chapter Organization
Introduction
The Theory of Optimum Currency Areas
Monetary Integreation: Cost Vs Benefits
Basic criteria: Old and New theory
Is the Eurozone an OCA ( case of Finland)?
Criticism of the theory
Summary

European Integration

Slide 16-1

Introduction

What Is an Optimum Currency Area?

It is a geographic region where try to maximize

economic efficiency through sharing a single currency.

Optimality depends on degree of economic integration.

Fulfillment of criteria

European Integration

Slide 16-2

Monetary Integreation: Costs and Benefits

Monetary Integreation: Costs

Loss of exchange rate
Loss of monetary autonomy
Constraints on fiscal policies
Monetary Integreation: Benefits
Price transparency
Increased efficiency
Reduced transaction costs
No need to have foreign currency reserves for central banks
Exchange rate stability
Increased policy credibility because devaluation is not possible
Firms enjoy benefits
Consumers get benefits

European Integration

Slide 16-3

Costs and Benefits

Figure 20-6: Deciding When to Peg the Exchange Rate
GG

Gains and losses

for the joining country

Losses exceed
gains

Gains exceed
losses

LL
1

Degree of economic integration

between the joining country and
the exchange rate area

European Integration

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Basic Criteria: Old and New Theory

Old theory: Economic Criteria
Labour mobility
Product diversification
Openness to trade
New theory: Political Criteria
Fiscal transfers
Homogenous preferences
Solidarity
European Integration

Slide 16-5

Old theory
(Economic Criteria)

Mundell Criterion :

Labor-and capital mobility can counterbalance asymmetric

shocks
Kenen Criterion :
Low probability and frequency that asymmetric shocks appear
McKinnon Criterion :
When countries are open to trade and trade heavily with each
other, giving up the exchange rate entails no serious loss of
policy independence

European Integration

Slide 16-6

New theory
(Political Criteria)
Fiscal Transfers:
Automatic fiscal transfers mechanism to distribute money to the
adversely affected sectors.
Homogenous preferences:
Common view on how ECB reacts to (symmetric) shocks.
Solidarity:
Solidarity among the member states
European Integration

Slide 16-7

Is the Eurozone an OCA?

Finland

Asymmetric shocks in the EMU?

Still:shock asymmetry as a danger for EMU

European Integration

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Asymmetric shocks

European Integration

Slide 16-9

Asymmetric shocks

European Integration

Slide 16-10

Does it fulfill all the factors?

Labour mobility
Product diversification

Trade openness
Fiscal policy
Homogenous preferences:
Solidarity

European Integration

Slide 11

Internal Migration across regions (% of total population-1995)

European Integration

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Product Diversification

European Integration

Slide -13

Does it fulfill all the factors?

Labour mobility ..
Diversification ...
Openness ...............
Fiscal transfer .
Homogenity of preferences
Solidarity .. ?

European Integration

Slide 14

Comparing Eurozone to USA

Case Study: Is Eurozone an Optimum Currency Area?.

By these criteria EU does not constitute an OCA and therefore the Euro
should be a suboptimum union of currencies.

Apply to USA
Labor is much more mobile within the U.S. than within Europe.
Lac of linguistic and cultural borders, budgetary federalism, the
greater relevance of statistical data, greater production
specialization.

European Integration

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Criticism
Mundells criterion has been the subject of many
disscussions and controversies.
Labour mobility
Fixed Vs Flexible Exchange rate
Traditional macroeconomic objectives
Liquidity properties of money
Kenens complexitiy

European Integration

Slide -16

Summary
If EMU fails the goal of European political unification
will be set back.

Europe is not an optimum currency area.

Economic union is so far in front of political union.
EU labor markets are very rigid.
SGP constrains fiscal policies.

European Integration

Slide 17

Thank You for your

Attention!