EC4333: European Economy
Topic 9: Optimum Currency Areas
The Question
 The question of a single currency in a large area
 Does it make good economic sense for each country
to have its own currency?
 What is the optimum size of a currency area?
 Should currency area borders coincide with national
borders?
 Is it a good idea for California to be on the US dollar?
EC4035: Economics of Integration
The (Economic) Answer
 Benefits and costs involved in adopting a
common currency
 The solution has to involve trading off these
costs and benefits
EC4035: Economics of Integration
The (Economic) Answer
EC4035: Economics of Integration
Focusing on Costs
 No precise way of estimating costs (or benefits)
so, in the end, a matter of judgement
 Benefits taken as given
 Look at the costs
 Asymmetric shocks
 How they create trouble
 What makes them more likely
 What makes them less painful
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In a Nutshell…
 The benefits
 Usefulness of a currency grows with the size of
the area over which it is used
 Money exhibits increasing returns to scale
 The costs
 Loss of monetary and exchange rate instruments
 Matters in presence of:
 Price and wage stickiness
 Asymmetric shocks
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Basic Idea
 Diversity translates into asymmetric shocks and
the exchange rate is very useful for dealing
with those shocks!
 But, if you join a currency union…
EC4035: Economics of Integration
A Demand Shock – Can the Exchange Rate
Help?
EC4035: Economics of Integration
Asymmetric Shock in a Currency Union
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Asymmetric Shock in a Currency Union
 After an asymmetric shock moving demand for country
A from AD to AD'
 Country A wants a depreciation according to a new
equilibrium B, and real exchange rate λ1
 Country B unhappy, as for the same real exchange
rate it faces inflationary excess demand B''-B'
 However, with unchanged real exchange rate λ0,
country A faces excess supply A-A'
EC4035: Economics of Integration
Implications of Asymmetric Shocks
 Both countries are hurt when they share the
same currency
 This is an unavoidable cost
 Next questions
 What reduces the incidence of asymmetric shocks?
 What makes it easier to cope with shocks when they
occur?
 The analysis develops six OCA criteria
EC4035: Economics of Integration
Six OCA criteria
 Three classic (economic) criteria
 Labour mobility (Mundell)
 Production diversification (Kenen)
 Openness (McKinnon)
 Three political criteria
 Fiscal transfers
 Homogenous preferences
 Solidarity v nationalism
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Criterion 1 (Mundell): Labour Mobility
 In an OCA, labour moves easily across national
borders
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Criterion 1 (Mundell): Labour Mobility
 Caveats
 Labour mobility is easy within national borders
(culture, language, legislation, welfare, etc.)
 Capital mobility: difference between financial and
physical capital
 In presence of country specialisation, skills also
matter
EC4035: Economics of Integration
Criterion 2 (Kenen): Production
Diversification
 Countries whose production and exports are
widely diversified and of similar structure form
an OCA
 Indeed, in that case, there are few asymmetric
shocks and each of them is likely to be of small
concern
EC4035: Economics of Integration
Criterion 3 (McKinnon): Openness
 Countries which are very open to trade and trade
heavily with each other form an OCA
 Distinguish between traded and non-traded goods
 Traded good prices are set worldwide
 A small economy is price-taker, so the exchange rate does not
affect competitiveness
 If all goods are traded, domestic good prices must be
flexible and the exchange rate does not matter for
competitiveness
EC4035: Economics of Integration
Criterion 4: Fiscal Transfers
 Countries that agree to compensate each other
from adverse shocks form an OCA
 Transfers can act as an insurance that mitigates
the costs of an asymmetric shock
 Transfers exist within national borders
 Implicitly through the welfare system
 Explicitly in federal states
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Criterion 5: Homogeneous Preferences
 Countries that share a wide consensus on the
way to deal with shocks form an OCA
 Matters primarily for symmetric shocks
 Prevalent when the Kenen criterion is satisfied
 May also help for asymmetric shocks
 Better understanding of partners’ actions
 Encourages transfers
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Criterion 6: Commonality of Destiny
 Countries that view themselves as sharing a
common destiny better accept the costs of
operating an OCA
 A common currency will always face
occasional asymmetric shocks that result in
temporary conflicts of interests
 This calls for accepting such economic costs in the name of a
higher purpose
EC4035: Economics of Integration
Six OCA criteria
 Three classic (economic) criteria
 Labour mobility (Mundell)
 Production diversification (Kenen)
 Openness (McKinnon)
 Three political criteria
 Fiscal transfers
 Homogenous preferences
 Solidarity v nationalism
EC4035: Economics of Integration
Overall
 The OCA glass is half full, or half empty
 Living in a monetary union may help fulfil
the OCA criteria over time
EC4035: Economics of Integration
In the End….
Monetary union is not only about
economics!
EC4035: Economics of Integration