the theory of optimum currency areas: a critique

Question 1

what are the three levels that can be formulated as a critique of optimal currency area theory?

Answer 1

how relevent are the difference between countries?
will some of the differences disappear when countries join EMU?
is national monetary policy effective

Question 2

what is the convergence criteria for joining the euro area?

Answer 2

price stability
sound public finances to ensure they are sustainable
exchange rate stability to demonstrate that a member state can manage its economy without recouse to excessive currency fluctuations
long term interest rates to assess the durability of the convergence

Question 3

how is monetary policy decided in the eurozone?

Answer 3

the european central bank ECB was established with a strict madate to maintain price stability through monetary policy

Question 4

how is the fiscal policy decided in the eurozone?

Answer 4

the stability and growth pact SGP set binding constraints on each member countries fiscal policy

Question 5

what were the economic convergences which occured prior to the euro?

Answer 5

the reduction of inflation differentials
convergence in nominal interest rates
convergence of maturity structures and yields of govt bonds

Question 6

what are some differences which remain or have widened after the euro?

Answer 6

differences remain in inflation rates and real interest rates
divergence in productivity and competitiveness
divergence in current account balances

Question 7

what three countries experiences rapid increases in economic activity and higher than average inflation prior to 2008?

Answer 7

spain ireland and portugal

Question 8

what hampered real convergence prior to 2008?

Answer 8

persistent inflation differentials and converging nominal interest rates hampered real convergence prior to 2008

Question 9

what would be the effect of eliminating exchange rate risks and other obstacles?

Answer 9

the elimation of exchange rate risks and other obstacles might drive capital towards catching up economies, stimulating investment and fostering economic growth

Question 10

what is the importance for cyclical shocks in a single currency area?

Answer 10

assymetric shocks lead to asymmetric buisiness cycles which increase the cost of a single currency area (Mundell, 1961)

Question 11

how does the financial intergration and boosted intra euro area capital flows relate to financial cycle convergence?

Answer 11

The elimination of exchange rate risks and the lowering of interest ratesincreased financial integration and boosted intra-euro area capital flows.
The increases in cross-border capital flows could enhance more efficient capital allocation, boost growth and result in more synchronised financial cycles
On the other hand, freer capital flows may also destabilize business cycles and real convergence if capital flows feed speculative bubbles in boom times and capital flight exacerbates downturns in crisis times.

Question 12

what are the potential effects of a downturn in the financial cycle?

Answer 12

– Exacerbating the business cycle downturn;– Lowering TFP growth (Cecchetti and Kharroubi, 2015);– Reflecting resource misallocation across sectors (Borio et al., 2015) and within firms (Adler et al., 2017)

Question 13

before the monetary union what would countries who experience a financial downturn do to restore competitiveness?

Answer 13

when these countries were not in a monetary union, hey would have been able to devalue their currencies, thereby making it possible to restore their competitiveness in a single stroke.

Question 14

what are the price and cost effects of a national monetary policy after monetary expansion?

Answer 14

after monetary expansion real wage declines, workers will want to be compensated by higher nominal wage
supply shifts upwards thereby reducing the output effect of monetary expansion
nominal exchange rate changes only have temporary effects on relative prices
however, monetary expansion can sometimes make the dynamics towards new equilibrium less costly than alternative policy strategies

Question 15

what are the effects of currency depreciation and deflationary polices?

Answer 15

french output is restored through defaltion
nominal wage decline
price of french produced goods decline
price of imported german goods become relatively more expensive
french workers have to accept low real wages due to the loss of purchase power

Question 16

how does a monetary expansion compare to currency depreciation and defaltionary policies?

Answer 16

• Both within and outside a monetary union, to restore initial output level, French workers need to accepted lower real wages
  .* In the perfect world with no money illusion, the situation faced by workers is the same within and out with a monetary union.
• With money illusion, workers will resist a reduction of their nominal wages more than a domestic currency depreciation.
• Therefore, it is more costly, in term of lost output, to adjust to a demand shock in a monetary union than outside the union

Question 17

what are the budgetary implications of the two adjustment mechanisms?

Answer 17

in a monetary union, a country has to reduce wages and prices. this leads to an increasing budget deficit and a surge in government debt levels.
members of a monetary union have no control over the money in which they have issued their debt. this makes them vulnerable to self fulfilling speculative attacks that can lead to a liquidity crisis, which in turn can lead to a solvency crisis

Question 18

what is the summary of the critique of the optimal currency area?

Answer 18

the adjustment mechanisms under the EMU have been insufficient to support convergence and have in some cases contributed to divergence
capital flows did not generarate convergence of productivity or of sustained real incomes. instead it led to divergence in current accounts and competitiveness in euro area countries
independent monetary can sometimes make the dynamics towards new equilibrium less costly than alternative policy strategies