Eurozone/Tutorials

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Tutorials relating to the topic of Eurozone.

Optimum currency area theory

Optimum currency area theory adopts the presumption that a currency area confers a benefit upon its members by eliminating exchange rate risks and reducing transactions costs. Its analysis concerns the extent to which that benefit may be offset by the risk of an additional cost when there is a recession. Such an additional cost arises when there is a difference between the monetary policy response to the recession that is appropriate for a member country, and that which is appropriate for the currency area as a whole. When that happens, some member countries may suffer unemployment and other economic costs that they could have avoided if they had retained control over their national monetary policies. It is liable to happen when the currency area experiences an asymmetric shock which affects the economies of some member countries more than others.

The term "optimum currency area" (OCA) is believed to have been coined by the eminent economist Robert Mundell to denote the concept of an area within which there would be no such offsetting costs. Mundell's analysis demonstrated that a sufficient condition would be either a frictionless migration of labour, or a frictionless adaptation of labour and product costs, in response to a recessionary change in demand[1]. Robert McKinnon has proposed openness as an alternative criterion, arguing that open economies tend not to experience price rigidities[2], and Peter Kenen has proposed economic convergence as another alternative, arguing that asymmetric shocks would not occur in the absence of economic differences among the economies of member countries[3]. Later studies have examined the effects upon the OCA criteria of changes to member states' economies that might take place as a result of membership, and some authors believe that the criteria could be satisfied as a result of convergence after joining even if they are not fully satisfied before[4]. On the other hand, it has been suggested that there may be increased national specialisation as a result of improved trading opportunities, promoting divergence rather than convergence[5].

Academic contributions to the debate about the eurozone as a currency area have been summarised by Kenneth Rogoff[6].

OCA theory and the Eurozone

The eurozone does not meet Mundell's labour migration or cost flexibility requirements. Labour mobility is low[7] and there is limited wage and price flexibility[8][9]. There have also been large differences in economic and financial structures[10]. One study has suggested that the initial expectation that membership would promote convergence has not been realised[11]. Another has detected a trend toward price convergence[12] although not necessarily as a result of eurozone membership. The eminent economist, Kenneth Rogoff has reviewed the evidence and concluded that Europe may never be an “optimum” currency area, and that, without further profound political and economic integration the euro may not survive even to the end of the decade[13].

References