Feb 19 2004

Lesson 5

By

John Kennes

International Monetary Economics

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Optimum Currency Areas

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Should currencies coincide with national borders?

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Is the US an optimal currency are?

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• What countries stand to benefit from sharing the same currency?– The OCA theory provides a set of criteria.

• Are these criteria filled for Europe?– Some critera are filled, but not others– Illustrates the unending debate– Illustrates potential problems that may surface, and

suggest some answers.

Optimal Currency Area (OCA) theory

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1. Transactions costs

– Money is more useful the wider it is excepted

2. Asymmetric shocks

– The Case for a California dollar (High tech shocks)– The Case for an Alberta dollar (Oil shocks)

Tradeoffs

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• Benefits – Money exhibits increasing returns to scale (network

externatilies)

• Costs– Loss of monetary and exchange rate instruments– Matters in the presence of:

• Price and wage stickiness• Asymmetric shocks

Size matters

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Size matters

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Start with the idea that there are benefits to a common currency

– Few widely excepted models of transaction costs: search models, menu costs models, etc. Still much work needs to be done by theoriests. Need models with explicit welfare functions.

Ask why not. Look at the costs.

The argument

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• No precise way of estimating costs and benefits so, in the end, a matter of judgment.

• Look at asymmetric costs:

– How they create trouble– What makes them more likely– What makes them less painful.

Estimating costs and benefits

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Asymmetric Shocks: How can the exchange rate help?

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Adverse Demand shock in a two country currency

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Both countries are hurt when they share the same currency.– Also the case when a symmetric shock creates

asymmetric effects

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

Implications of Asymmetric shocks

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• In an OCA labor moves easily across national borders

• Caveats– Labor mobility is easy within national borders

(culture, language, legislation, welfare, etc)– Capital mobility: differences between financial and

physical capital– In presence of country specialization, skills also

matter

Criterion 1 (Mundell): Labor mobility

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• Countries whose production and exports are widely diversified and of similar structure form an OCA

• Indeed, in this case, there are few asymmetric shocks and each of them is likely to be a small concern

Criterion 2 (Kenen): Production Diversification

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• Countries which are very open to trade and trade heavily with each other form an OCA.

• Distinguish between traded and nontraded goods:– Traded good prices are set world wide– A small economy is price taker, so exchange rate

does not affect competiveness

• In the limit, if all goods are traded, domestic gods prices must be flexible and the exchange rate does not affect competiveness.

Criterion 3 (McKinnon): Openness

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• Countries that agree to compensate each other for adverse shock form an OCA

• Transfers can act as an insurance that mitigates the cost of an asymmetric shock

• Transfers exist within national borders: – Implicitly through the welfare system– Explicitly in federal states

Criterion 4: Fiscal transfers

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• 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 with asymmetric shocks:– Better understanding of partners actions– Encourage transfers

Criterion 5: Homogeneous Preferences

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Criterion 6: Commonality of Destiny

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Is Europe an OCA?

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Is Europe an OCA?A synthetic OCA index

(Bayoumi and Eichengreen 1997)

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• Read their methodology.

• How do they incorperate the 6 criteria?

• Notice that most of the countries at the top of the list did not join the euro in the first round

Is Europe an OCA?A synthetic OCA index

(Bayoumi and Eichengreen 1997)

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Is Europe an OCA?Asymmetric effects of symmetric shocks: effects of GDP and

prices of a change of the common interest rate

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Note that textbook has misprinted figure 13-6

Is Europe an OCA?Asymmetric effects of symmetric shocks: effects of GDP and

prices of a change of the common interest rate

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Inside the OCA indexMost EU countries are very open

McKinnon criteria is broadly satisfied.

Difference in trade structure relative to that of its partners

Inside the OCA index: DiversificationMost EU countries have diversified production

Kenen criterion broadly satisfied

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• The labor mobility criterion cannot be black and white

Inside the OCA index: Labor Mobility

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• The labor mobility criterion cannot be black and white

• The migration response to econmic incentives must factor in many costs

– Moving costs– Risks of being unemployed– Longer run career prospects– Family prospects– Eligibility for welfare– Taxation– Cultural/ lingusitic difficulties– National attachment

Inside the OCA index: Labor Mobility

External migration

Inside the OCA index: Labor MobilityInternational comparisons suggest labor mobility is low in

Europe

Internal migration

Inside the OCA index: Labor MobilityInternational comparisons also suggest intranational labor

mobility is low in Europe

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• Low mobility implies that unemployment bears much of the adjustment to shocks

• A US EU comparison (Fatás 2000)

Inside the OCA index: Labor Mobility

EU-US Impulse response (Fatás 2000)

Inside the OCA index: Labor Mobility

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The EU does not satisfy the transfer criterionThe overall EU budget- Is low, capped at 1.27% of EU GDP- Entirely used for administration, CAP, regional

and structural funds

Inside the OCA Index: Transfers

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Little is known about this criterion

Inside the OCA Index: Homogeneity of Preferences

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• Little is known about this criterion• Public opinion polls do not dedect deep

opposition to EU institutions

Inside the OCA Index: Commonality of Destiny

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Inside the OCA Index: Commonality of Destiny

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OCA-glasset er enten halvt tomt eller halvt fyldt

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• Living in a monetary union may help fulfill the OCA criteria over time

• Would the US be an OCA without a common currency – chicken egg

• Will the existence of the euro change matters too?

History never ends: The endogeneity of OCA criteria

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• Little evidence that reducing exchange rate volatility increases trade

• Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot– Estimate from 50% to 100%– The border effect provides similar estimates

Will trade deepen?

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• Argument 1: Intra-industry trade will grow• Argument 2: Specialization will increase• No firm conclusion so far.

Will Diversification grow or decline?

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• Mobility may not change much, but wages could become less sticky

• Two views– Virtuous circle: labor market responds to enhanced

competition by becoming more flexible– The hardening view: labor markets respond to

enhanced competition by increasing protective measures that raise stickiness

• The jury is still out.

EMU and Labor Markets

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• Transfers:– Currently no support for more taxes to finance

transfers

• Homogeneity of preferences– No presumption that it will chnage soon.

• Commonality of destiny– No presumption that it will chnage soon.

Are other criteria endogenous?

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• Monetary union is not only about economics• The OCA criteria do not send a clear signal

– The EU is not a perfect OCA– A monetary union may function, at a cost

• The OCA criteria tells us where the costs will arise– Labor markets and unemployment– Political tensions in presence of deep asymmetric

shocks.

In the End