5b: Optimum Currency Area

Question 1

Is a Large Currency Area Desirable?

Answer 1

• Lower transaction costs, risk avoidance, factor mobility etc.
• Diversity leads to a variety of problems, like economic discrepancies, bail out issues, heterogeneity of interest rate preferences, political issues etc.
• The usefulness of a currency grows with the size of that area, thus its marginal benefit is positive.
• The growing diversity of a union represent costs (political and economic).

Question 2

Mundell Criterion

Answer 2

1. Labour Mobility: OCAs are those within which people move easily.
This DOES NOT hold in the EMU:

• Different languages, bureaucratic systems and legislation hamper mobility.
• Nationally different products may imply long (re-)train periods.
• The point that capital is mobile only holds partially for this analysis, as a country may be using all its capital/equipment

Question 3

McKinnon Criterion

Answer 3

2. Production diversification: Countries whose production and exports are widely diversified but are of similar structure form an OCA.
This DOES hold in the EMU:

• Asymmetric shocks cause problems, but they happen rarely. When we talk about countries, a long and profound demand shift from wine to beer (and thus - hypothetically - from France to Germany) does not affect the overall economy.
• The countries most likely to be affected are countries that specialize in the production of a narrow range of goods.
• Thus: If countries show well diversified economies and produce similar goods, the impact of asymmetric shocks is generally low.

Question 4

Kennen Criterion

Answer 4

3. Openness: Countries that are very open to trade and trade heavily with each other form an OCA.
This DOES hold in the EMU:

• When France and Germany trade heavily with each other but do not share the same currency, exchange rate influence market prices.
• With monetary integration the exchange rate no longer exists as an important adjustment tool for competition.
• The more interlinked/open countries are, the bigger the influence of competition on market prices.

Question 5

Fiscal Criterion

Answer 5

4. Fiscal transfers: Countries that agree to compensate (insure) each other for adverse shocks form an OCA.
This DOES NOT hold in the EMU:

• If there was an asymmetric shock, Germany could help France to get out of this situation by financially compensating the country.
• about to change: With the EFSF and the ESM mechanisms the European countries can guarantee for another country in case of a default. However they have not transferred any money yet!

Question 6

Preference Criterion

Answer 6

5. Homogeneous Preferences: Currency union member countries must share a wide consensus on the way to deal with shocks.
This holds PARTLY, but differences are increasingly visible.

• Given that France and Germany do face a recession, they need to know how they will handle the problem (!).
• Differentiate between increasing inflation or increasing unemployment.

Question 7

Solidarity Criterion

Answer 7

6. Solidarity: When the common monetary policy gives rise to conflicts of national interests, the countries that form a currency need to accept the costs in the name of a common destiny.
The EMU’s fate will in the end be decided by this question!

• Even in individual countries, these interests are not necessarily shared by all groups of that society.
• In countries the costs of such disputes is settled by the benefit of living together.
• necessary for people to have a sense of common destiny that outweighs nationalist tendencies that would otherwise call for uncompromising reactions.