Optimum Currency Area Theory
Grzegorz Tchorek
Ph.D.
Warsaw University
I have very king request…
The outline of our course
1. Evolution of the OCA theory, which has a lot of
weaknesses as an analytical framework, but is the
only one relatively coherent economic approach
to monetary integration.
2. Experiences of the euro area and causes of the
crisis and we will try to juxtapose what we
thought about the euro area functioning before
the euro creation and before the crisis and what
happened as a result of the crisis.
3. Reforms and prospects of the euro area and
the UE
Is the euro area safer now ?
The euro zone: Is this really the end?
Economist
November 26, 2011
„Super Mario” saved the euro ?
Theoretical aspects of monetary integration,
- Evolution of the Optimum Currency Area (OCA)
Arguments in favour of the euro adoption
• Direct effects
- Elimination of the costs related to zloty/euro
exchange rate transactions
- Elimination of exchange rate risk
- Decline in interest rates (mainly long term)
• Long-term benefits
- Investment growth (FDI)
- Trade expansion
- Decrease in the country’s macroeconomic risk
- Financial markets integration ( home bias)
- Increased competition
- More stable environment
Costs and threats of the euro adoption arguments for slow monetary integration
Monetary union membership involves major macroeconomic
costs:
• Giving up an independent interest rate policy and a
floating exchange rate,
• The risk of ECB monetary policy being inappropriate
for the Polish economy
• Potential short-term cost of meeting the inflation
criterion
…and also changeover costs
In order to recognize benefits, costs,
opportunities, threats and challenges on the
road to euro area we will turn to the economic
theory and empirical studies
The basis is still OCA theory …
in its old (real convergence) and new (nominal
convergence) view
Two opposite views on the monetary
integration
Real convergence
Nominal convergence
• Gives a lot of profits (elimination
•How to avoid asymmetric shocks of exchange rate risk, more stable
after abandoning monetary policy ? environment, more trade and
investment),
(susceptibility to shocks)
•The credibility issue and the
•How to cope with these shocks ? importance of a nominal anchor in
monetary union,
(economic flexibility)
•Endogenous effects
•Nominal convergence approach induces fast
joining,
•Real convergence approach indicates rather
gradual integration,
The “Pioneering Phase” - from the early 1960s to
the early 1970s
• The OCA theory emerged from the debate on the
merits of fixed versus flexible exchange rate regimes
• The pioneering phase initiated a debate on the
benefits and costs of adopting a single currency.
• “Problem of inconclusiveness” - as OCA properties may
point out different directions,
• Several properties were difficult to measure
accurately and evaluate
Asymmetric shock and internal and external balance in two countries
Germany
A- country
Spain
B – country
Price
level
Price
level
S0
S0
E0
E0
PB1
PA0
D0
D0
0
0
QA0
P - Price level,
Q- Quantity of production,
S – aggregate supply curve,
D- aggregate demand curve
QA
QB0
QB
Asymmetric shock and internal and external balance in two countries
Germany
Spain
Price
level
Price
level
S0
S0
E1
PA1
E0
E0
D1
PA0
PB1
PB0
E
2
D0
D0
0
D1
0
QA0
QA1
QA
QB1
QB0
How can we restore balances in two countries?
QB
The first option is Exchange rate policy
•Germany can revalue its currency/ or if they have a floating exchange
rate, it will probably appreciate automatically
•Spain can devalue its currency/ or if they have a floating exchange rate,
it will probably depreciate Spain currency
The second option is Monetary policy
•Spain can decrease its interest rates in order to help firms and
households
•Germany can increase its interest rates in order to avoid excessive
surplus and inflation
The third option is fiscal policy
•Spain can decrease taxes
•Greece can increase taxes
In a fiscal union transfer between countries can be used as a shock
absorber
…The fourth option is structural policy – but in a long run..
•Mundell and his successors stated that
one country can give up its monetary and
exchange rate policy when it fulfills some
criteria which are called optimum
currency area conditions.
• They constitute a substitution
mechanisms to the monetary policy
The main issues of the OCA are:
• How to cope with these shocks ? (economic
flexibility)
• How to avoid asymmetric shocks ?
(susceptibility to shocks)
Factors which help countries to cope with shocks
- Production factors mobility (including labour) –
(Mundell 1961, Corden 1972)
- Price and wage flexibility (labour and product
market flexibility) – (Friedman 1953, Mundell 1961)
- Financial market integration (Ingram 1962)
- Fiscal integration (Kenen 1969)
Production factors mobility, mainly labour mobility
– unemployed Spaniards should go to work to Germany
• But labour mobility is constrained by a lot of factors like
cultural and language differences, the lack of a common social
benefit system, etc.
• Finally, Mundell diminished the importance of this
criterion because people cannot move in reaction to every
shock (particular shocks repeat with every economic
cycle, it can have different consequences in the phase of crisis
even if countries are highly synchronized during a boom ).
• On the other hand, nowadays, justification for labour mobility
is lower because factories follow labour (FDI)
Labour market integration
• There are significant barriers in the housing
markets across the EU.
• A panel of experts set up by the EU attributes low
labour mobility to a combination of institutional
and administrative factors including:
– limited cross border portability of social protection and
supplementary pension rights;
– administrative difficulties and the high costs of gaining
legal resident status;
– lack of comparability and reciprocal recognition of
professional qualifications;
– and restrictions on public sector employment.
•
•
•
•
Wage and price flexibility
According to the theory, people in the country affected by a
negative shock should be able to decrease their salaries, which
could lead to lower prices and increasing international
competitiveness
The problem is that wages and prices are rigid, especially in
the short term.
For these reasons price flexibility (and labour mobility)
can be an efficient adjustment mechanism in the
medium and long term – People will not agree to change
salaries if they are not sure that economic conditions have
changed permanently
Nowadays in many sectors wages are not the main
source of costs in companies
Price and wage flexibility as an alternative to the nominal
exchange rate adjustment..?
• Price and wage elasticity can be an efficient adjustment
mechanism rather in the medium and long term – it is
called the real exchange rate adjustment channel
(instead of nominal)
• The problem is that when nominal exchange rate
change is needed, market forces lead to it - a country
affected by a negative shock will usually experience currency
depreciation.
• So this change is not subject to negotiation. When you
have to change prices and wages (as well as hire people), it
can be difficult and tough. This is the main reason why this
process is slow and costly
Greece
Poland
Spain
Austria
Germany
Italy
Neth.
Luxemb.
Portugal
Sweden
Belgium
Denmark
Finland
France
UK
140
Ireland
US
160
Doing Business. Starting a Business - Rank
2008
120
100
80
60
40
20
0
Financial market integration criterion
Countries sharing a single currency can mitigate the effects of
asymmetric shocks among them through the diversification of
their income sources, by adjusting their wealth portfolio,
• through capital market - savings channel – diversification
of assets before the shock (ex ante insurance)
• through credit market - credit channel – shock absorption
through access to a liquid financial market (ex post
insurance)
The result of the discussion was the conclusion that similarity
of shocks is not a strict prerequisite for sharing a single
currency if all members of the currency area are financially
integrated and hold claims on each other’s output
• This channel can work when agents in both countries are able
and willing to diversify their assets
• In our case households in Spain buy Spanish and German car
companies’ shares (the same in Germany)
• In case of an asymmetric shock, Spaniards lose on Spanish
shares but they compensate it through profits from German
companies
• Germans earn on German shares but lose money on Spanish
ones.
• In this way, financial market integration serves as an
insurance system
• Taking into account crisis experiences, we know that the
ability of financial markets to smooth economic cycle
differences between countries appeared weak. Moreover,
financial market integration was the main cause of contagion
Fiscal and political integration
• In our case (Germany vs Spain) increased tax revenue
in Germany should be transferred to the common
budget and furthered to Spain
• Such a situation demands some form of political
union and ability of central institutions to impose
taxes in individual countries
• Due to the lack of social and political integration the
UE budget is very small and dedicated to functions
other than stabilization
• Nowadays we are discussing the future shape of
fiscal policy and fiscal union but it is difficult to
establish them when you are in crisis
• As George Soros said, Europe was to be
cooperation of equal countries but because of
the crisis now it has become a confederation
of debtors and creditors.
• In such circumstances it is difficult to establish a
level playing field. Insurance mechanisms should
be established ex ante
• Economic integration should be accompanied by
political
Consumption
Governmnent
Investment
Export netto
12,0
Increasing role of fiscal policy
in montery union
7,0
2,0
-3,0
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
-8,0
Factors which make countries less susceptible to
shocks
Meta property as a result of reconciliation phase
“Symmetry” of shocks
• Correlation of the business cycles (one monetary policy
fits all)
• Production diversification as well as similarity of economic
structure (sectoral, supply, and demand distribution of the
GDP,
• Trade integration (The degree of economic openness –
McKinnon 1963) ?
• Similarity of inflation rates (Fleming 1971, Ishiyama 1975)
Trade openness
• Openness of the economy is a special OCA
property/measured by trade to GDP
• First, in good times it is a channel through which the
economy is tied to the rest of the monetary union and
benefits from prosperity
• Second, in bad times it is also a channel connecting
one economy with the monetary union but in a
negative way
• Shock transmission depends on the degree of
openness
- Poland as an axample….and the most open
countries as Ireland, Belgium
Trade openness
Costs of
abandoning
monetary policy
Trade/GDP
-the more open the economy is, the more benefits can be achieved
from the elimination of transaction costs (lower cost of monetary
abandoning)
Usefulness of exchange rate adjustment
decreases with increased degree of openness.
Why is it so?
• The more open the economy, the greater share
of import input.
• It means that when you depreciate/devalue your
currency, it affects import prices and costs of
external debt service (they increase) and with
some lags leads to the general price increase
• that is why indebted countries should do not
leave the euro ….
Diversification of production
•In Mundell`s model we assumed two countries and one good
which is traded across borders
•In the reallity world this is more complex. A stable economy
should not be dependent on one dominant activity.
•If you have more diversified structure of your production and
export, the probability of a severe shock is lower
•A good example of monocultural production is Slovakia (about
50 % of its export production is concentrated on machinery
equipment) as well as Spain and Ireland in the past when almost
20 % of their GDP was concentrated in the construction sector.
Similarity of inflation rates between countries
In the monetary union the issue of real exchange rate
channel (measured by the level of prices and costs)
becomes more important. This is the feature which relates to
two important factors:
1. Similar rates of inflation prevent excessive shifts in price
competitiveness among countries – lose of export
market share
2. This condition is rooted in Maastricht Treaty in price
convergence criterion in order to avoid differences in real
interest rates
•After creating the monetary union the euro area has
one nominal interest rate but in case of different
inflation at national level real interest rates are
diversified
•Real interest rate = nominal interest rate – inflation
•Due to higher inflation rates, peripheral countries
experienced lending and consumption booms
The “Reconciliation Phase” - the 1970s
•Slowing down of integration processes in Europe due to
oil crisis and break up of Bretton Woods System
•Assess balance of costs and benefits of monetary integration
• The criteria have become more evident
•The importance of the OCA properties have changed to
some extent
Some observations on the “reconciliation phase”
•Reconciliation strengthened the interpretation of some
properties and led to diverse new insights such as the role of
similarity of shocks – called “symmetry” meta property,
because of its importance
•Ishiyama points out that differences in inflation rates
and wage flexibility are of the utmost importance
•The usefulness of a common currency depends on the
openness of the country,
•Countries prone to shocks should cast an anchor in a
more stable environment and import its monetary (antiinflationary) credibility (McKinnon)
Some observations on the “reconciliation phase”
•A new “meta-property” was advanced: i.e., the similarity of
shocks -openness and similarity of shocks are also very
important,
• Mundell (1973) argues that if members of a currency area
are financially integrated, a high similarity of shocks
among them, although desirable, is no longer a strict
prerequisite.
•Mobility of factors of production and labour is highly desirable
but also entails some costs and cannot effectively cope with
disturbances in the very short-term.
• For Ishiyama, similarity in price and wage inflation ranks the
highest.
The “Reassessment Phase” the 1980s
and early 1990s
• When interest in European monetary integration re-emerged
in the mid 1980s, economists looked back at the OCA
theory, but could not find clear answers to the question
whether Europe should proceed towards complete
monetary integration.
• At the end of this reassessment phase a “new” OCA theory
starts emerging in relation to the “old” OCA theory (Tavlas
(1993)).
The OCA changed owing to the reassesment:
– of the Phillips Curve - neutrality of money in the
longer term
– the credibility issue (import credibility)
– the importance of a nominal anchor,
– The (in) effectiveness of exchange rate changes.
• There are somewhat fewer costs in terms of the loss
of autonomy of domestic macroeconomic policies
• There are also more benefits, due to credibility
gains, for countries with a track record of higher
inflation (prior to adopting common currency)
The “Reassessment Phase”: the 1980s and Early 1990s
• One of the main perceived costs of monetary integration
is that member countries lose direct control over their
national monetary policy.
•
This prevents them from undertaking business-cycle stabilisation: the
cost that is represented by wider cyclical fluctuations is more severe
when shocks are asymmetric
However, monetarist critique of the short-term constant
Phillips curve showed neutrality of money in the longer
term,
• It means that a change in the interest rates affects only nominal variables
in the economy such as prices, wages and exchange rates, having no
effect on real variables like GDP, employment and consumption
• Hence, from this standpoint, the costs of losing direct control over
national monetary policy are low.
•
The Credibility Issue
(increases the role of stable and predictable
macroeconomic policy)
• The ability of a country to achieve and maintain low
inflation is important while evaluating the costs of
monetary integration.
• Some governments could have an incentive to abandon a
low inflation commitment that has been accepted at face
value by the public in order to reduce unemployment
along some short-run Phillips curve (Kydland and Prescott
(1977) and Barro and Gordon (1983)).
• Similarly, devaluations can also cause strong and longlasting inflationary expectations
The Credibility Issue
• For a country with a track record of relatively higher
inflation and a reputation for breaking low inflation
promises, a way to immediately gain a low-inflation
credibility is to ‘tie its hands’ by forsaking national
monetary sovereignty and establishing a complete
monetary union with a low inflation country (Giavazzi
and Giovannini (1989))
• Similarities of inflation rates could be a feasible outcome
from participating in a monetary union but is not a
necessary precondition (Gandolfo (1992)
• This turns around one of the main OCA properties provided
that the nominal anchor country can maintain the hegemony
of the institutional setting that have preserved the low
Negative consequences of excessive debt of public
sector
• The greater public sector, the smaller role of private
sector. We can justify it as follows: Market forces are the
only way to stimulate labour productivity which is the
fundamental growth factor in the long term. Crisis episodes
usually confirm that absolutely free market should be
subdued to regulations, but market forces give better
incentives to growth than administrative decisions
• Huge share of public sector can lead to high social
expectations – One of the roots of the European crisis is
its relatively high level of social protection, which
sometimes is not accurately addressed.
The Merkel plan
Germany’s vision for Europe is all about making the
continent more competitive
Jun 15th 2013
• ….Mrs Merkel never tires of saying that
Europe has 7% of the world’s population, 25%
of its GDP and 50% of its social spending..
• Growing government spending leads to budget deficits
and public debt – which probably will be repaid by the next
generation rather than people who made the commitment
(borrowed money).
• There is a risk of crowding – out effect - it means that
growing borrowing needs of governments can cause interest
rate rise and lead to the situation where private investment
projects cannot be implemented because of high cost of
financing
• High interest rates can cause capital inflow and currency
appreciation - In turn, growing price of national currency
can undermine international price ccompetitiveness
• non - keynesian effect . According to Keynes assumptions,
when you have unused production factors, you should spend
money in order to employ them. Higher production will
generate new revenues and spending, so GDP should
increase.
• But when you have a huge level of public debt, further
borrowing can have counterproductive effects. Because
when Agents in the economy observe public indebtedness
instead of higher spending, they can increase savings (because
they expect future tax increases)
• So in case of huge indebtedness a better solution may be
to decrease taxes and administrative burdens to lower
budget deficit. It can have more fruitful effects than
continuing to borrow.
Are Exchange Rate Adjustments Effective in Each Case?
• Are changes in nominal exchange rate actually effective?
If not, the cost of losing direct control over the nominal
exchange rate instrument would be small
• Canzoneri, Vallés and Viñals (1996) show that the cost of
having no nominal exchange rate for countries joining EMU
is likely to be low because movements in exchange rates are
dominated by monetary and financial shocks preventing the
exchange rate from performing the macroeconomic
stabilisation function (Poland and PLN exchange rate
during crisis)
• Exchange rate changes operate instead with considerable lags
due to the slowness of the portfolio-balance channel
(Branson (1986)).
New interpretation of the OCA as
the justification for nominal
convergence criteria...
• The “new view” of the OCA corresponds to nominal
convergence criteria defined in Maastricht Treaty.
• Money neutrality in the long run (it means that you cannot
use your own monetary policy for your own purposes –it was
an argument for giving up incredible monetary policy in
peripheral countries)
• The necessity of keeping stable and credible economic
policy – after experiences in fiscal policy in the 70s and 80s it
seemed justified to take care of credibility of fiscal policy,
because high public debt could run out of control
• Insufficient exchange rate adjustment channel (increasing
capital flows and growing importance of financial markets
make financial assets prices unstable and dependent on shortterm investment horizons
The Maastricht Treaty specifies that EU member countries must
satisfy several convergence criteria:
• Price stability
– Maximum inflation rate 1.5% above the average of the
three EU member states with lowest inflation
– Long-term interest rates should not exceed by more
than 2 p.p. the interest rates of three best performing EU
countries in terms of price stability
• Exchange rate stability
– Stable exchange rate within the ERM without devaluing
on the country’s own initiative
• Budget discipline
– Maximum public-sector deficit 3% of the country’s
GDP, Maximum public debt 60% of the country’s GDP
Some observations on the “reassessment phase”
• The revisions to the analytical framework behind the “old”
OCA theory lead to a “new” OCA
• An important legacy of this phase is that there are
somewhat fewer costs in terms of the loss of autonomy
of domestic macroeconomic policies.
• There are also more benefits, due to credibility gains,
for countries with a track record of higher and more
variable inflation (the similarity of inflation property
can then be satisfied ex-post).
• Monetary union is likely to be more beneficial than what can
be presumed on the basis of the application of the OCA
properties alone.
The “endogeneity of OCA” issue
• It postulates a positive link between income correlation
and trade integration (this will in turn promote reciprocal
trade, economic and financial integration and business
cycle synchronisation among the countries sharing a single
currency)
• Rose and Frankel, based on the empirical research,
formulated the thesis of endogeneity of OCA
properties.
• They claim that one country does not have to fulfil
the traditional OCA criteria before joining the
monetary union. Instead, this country should join the
monetary union ex ante, and as a consequence of home
bias elimination, the fulfilment of condition would be
easier.
• That elimination of exchange rate risk and transaction costs
will provide huge trade increase between countries
• In the literature it is called “elimination of home bias” – it
means that agents in the economy are less attached to
local products and assets and they become more intra –
euro area oriented (in terms of trade in goods, services,
capital etc. ).
• Frankel (1999) singles out two of the OCA properties as
crucial in assessing the net benefits of the currency union:
– their degree of openness, i.e., the extent of reciprocal trade among
a group of partner countries,
– and their correlation of incomes
Countries sharing a high level of either openness or income
correlation, but preferably both properties, will find it
beneficial to share a single currency
Frankel notes that the optimum currency area properties
evolve over time. Most authors agree that reciprocal trade
and openness increase among countries sharing a single
currency
• But… there is disagreement though concerning the
extent to which income correlation rises or falls
following monetary integration and the effective
increase in reciprocal trade.
• Two opposite paradigms with different implications
have been put forward:
- specialisation
- endogeneity
• The first paradigm is the “Krugman specialisation hypothesis”
which is rooted in trade theory and increasing returns to scale
as the single currency removes some obstacles to trade and
encourages economies of scale.
• It postulates that as countries become more integrated
(and their reciprocal openness rises) they will also
specialise in the production of those goods and services
for which they have a comparative advantage (see
Bertola (1993),
• Members of a currency area would become less
diversified and more vulnerable to supply shocks.
Correspondingly their incomes will become less correlated.
• An increase in integration would move a country away from the OCA
line, e.g., from point 1 to point 2 (more openness and less correlation).
Frankel notes an apparent paradox of the argument that higher
integration leads to increasing specialisation that lowers
diversification, and in turn makes countries worse currency area
partners.
• Frankel and Rose present the following example. They start with
postulating that there is a group of countries which is initially at
point 1 in Figure. These countries are initially on the left of the
OCA line
• If these countries join together and form a “union,” such as the
European Union (EU), both trade integration and income
correlation within the group will rise: i.e., they will gradually move to
point 2.
• A country’s suitability for entry into a currency union may have to be
reconsidered if satisfaction of OCA properties is endogenous or
“countries which join EMU, no matter what their motivation may
be, may satisfy OCA properties ex-post even if they do not exante!” (Frankel and Rose 1997).
• Hence, one of the criteria for judging the suitability of countries for
EMU is turned around.
Nominal convergence
• Masstrich requirements provided a strong nominal
anchor
• However, many countries fulfilled the criteria because
of a favorable economic environment and falling longterm interest rates which led to lower interest rate
payment
• Deterioration of economic conditions starting in 2001
revealed that fiscal reforms undertaken had in many
cases been based upon a budget income increase and
one-off events, such as privatization.
Nominal convergence
•Moreover, in many cases reforms that were based on
reduction of expenditures were still incomlpete and
abandoned after the entry to the euro area.
•It was much easier to quickly achieve nominal convergence
criteria in the countries aspiring to the EMU than to ensure
its sustainability after adopting the single currency.
Nominal convergence
• The process of divergence started in the inflation rates
as well as deficit and public debt levels
• Consequently, increasing differences in the inflation
rates, accompanied by a common monetary policy brought
about different effects, depending on local conditions
determining the real price of money
• The price of money equal for all monetary members.
irrespective of the quality of individual countries’ economy
(“interest free ride”)
Nominal convergence
• Nominal convergence criteria constituted a mechanism of
supervision over the quality of economic policy
• The endeavor to meet the criteria was a historical
challenge, which helped to reduce fiscal imbalances and
to increase the stability of economic policy
• But many countries fulfilled the criteria because of a
favorable economic environment and falling long-term
interest rates which led to lower interest rate payment
• Unfortunately it undermined incentives for further
reforms
Nominal convergence
•Moreover, in many cases reforms that were:
• not based on reduction of expenditures
• still incomlpete
•abandoned after the entry to the euro area
•It was much easier to quickly achieve nominal
convergence criteria in the countries aspiring to the
EMU than to ensure sustainability of criteria
fullfilment after adopting the single currency
• The process of divergence started in the inflation rates as
well as deficit and public debt levels
Real convergence
• Real convergence criteria are evaluated on the basis of a
country’s economic development measured, inter alia, by GDP
per capita and by the synchronization of business cycles,
which reduces the risk of assymetric shocks
• Unexpectedly asymmetric shocks have not proved to be
a problem. However, the source of concern are the
differences in absorption of common shocks by individual
countries
• This was caused by significant differences in the structure of
demand and supply, as well as discrepancies in the sectoral
composition and degree of flexibility of economies
...but Synchronization of business cycles in EMU seems to be
a „cyclical” phenomenon,
Lessons from the euro area countries
• The balance of costs and benefits of membership in the
monetary union may depend upon how sustainable the
achievement of nominal and real convergence criteria is
• Because of weak structural convergence and flexibility
of economies some benefits have not always materialized,
whereas some costs and risks turned out to have been
underestimated
• A case-by-case approach based on country-specific
conditions seems to be necessary due to the differences
between the countries.
Real convergence in the euro area countries
• Fulfillment of real convergence criteria is evaluated on
the basis of a country’s economic development measured,
inter alia, by GDP per capita and by the synchronization of
business cycles.
• So far asymmetric shocks have not proved to be a
problem. However, the source of concern are the
differences in absorption of common shocks by
individual countries
Conclusions
• The balance of costs and benefits of membership in the
monetary union may depend upon how sustainable the
achievement of nominal and real convergence criteria
is.
• The overall effects of the euro that member states have
experienced so far are generally positive, though they have
varied among individual countries.
• Because of structural convergence and flexibility of
economies some benefits have not always materialized,
whereas some costs and risks turned out to have been
underestimated.
Efektywność systemu prawnego
– liczba dni potrzebnych do odzyskania należności