Introduction to Management and Organisational Behaviour

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Optimum Currency Areas
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Optimum Currency Areas?

• Should each country have its own national
  currency ?
• Currency is a symbol of statehood, along with
  national anthem, flag, and football team.
• Should country give up its currency in favour of
  another?
• Should regions within a country have their own
  currencies?
• How best to delineate currency areas?
• What economic criteria should be used?

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E.g. California in the early 1990s

• Is it good for California to use the US dollar?

4
The Economic Toolkit

• There are benefits and costs involved in adopting
  a common currency.
• The solution has to involve trading off these
  benefits.

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In a Nutshell

• Benefits
• No transaction costs, no exchange-rate
  uncertainty
• Decreasing with size of currency area
• Costs
• Economic and political diversity
• Loss of monetary and exchange rate instruments
• Increasing with size of currency area

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OCA Theory

• Focus on the costs of common currency
• Especially on asymmetric shocks
• What are they?
• What problems do they cause in currency unions?
• How can their effects be mitigated?

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Example A demand shock

• Real exchange rate, EP/P, must depreciate to
  restore competitiveness
• Either prices fall or nominal exchange rate
  depreciates.
• If not overproduction and unemployment

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Symmetric Shock

• Same demand shock in two similar countries that
  share the same currency and, therefore, exchange
  rate No problem. The same real XR adjustment as
  before.

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Asymmetric Shock

• Only one country is affected countries share
  common currency Problem!
• Country As real exchange rate must depreciate
  both vis-à-vis ROW and Country B

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Asymmetric Shock

• Country A wants a depreciation.
• Country B is unhappy depreciation would lead to
  excess demand and inflationary pressure.

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Asymmetric Shock

• Country B wants no change.
• Country A is unhappy because of excess supply and
  unemployment.

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Asymmetric Shock

• Common central bank considers preferences of both
  countries and allows partial depreciation
• Nobody is happy.

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Asymmetric Shock

• In the long, the problem is solved.
• How?

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Asymmetric Shock

• Prices decline in country A and rise in country
  B.
• Real exchange rate adjusts because of price
  adjustment.
• Equilibrium is restored in both countries through
  disinflation and recession in A and inflation and
  expansion in B.

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Implications of Asymmetric Shocks

• Both countries are hurt when they share the same
  currency.
• Also the case when a symmetric shock creates
  asymmetric effects.
• 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?
• Answer six OCA criteria.

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Six OCA criteria

• Three economic criteria
• Mundell
• Kenen
• McKinnon
• Three political criteria

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Criterion 1 (Mundell) Labour Mobility

• An OCA is an area within which labour moves
  easily (including across national borders).

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Criterion 1 (Mundell) Labour Mobility

• Labour moves from A to B
• The two supply curves shift
• Equilibrium is restored without
  disinflation/inflation.

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Criterion 1 (Mundell) Labour Mobility

• In an OCA labour (and capital) moves easily,
  within and across national borders.
• Caveats
• labour mobility is easy within national borders
  but difficult across borders (culture, language,
  legislation, welfare benefits, etc.)
• capital mobility difference between financial
  and physical capital physical capital is less
  mobile than financial capital
• in presence of country specialization, skills may
  also matter migrants may need retraining.

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Criterion 2 (Kenen) Production Diversification

• OCA countries whose production and exports are
  widely diversified and of similar structure.
• If production and exports are diversified and
  similar, there are few asymmetric shocks and each
  of them is likely to be of small concern.

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Criterion 3 (McKinnon) Openness

• Countries which are very open to trade and trade
  heavily with each other form an OCA.
• Traded vs non-traded goods
• traded good prices are set worldwide
• a small economy is price-taker, so the exchange
  rate does not affect competitiveness.
• In the limit, if all goods are traded, domestic
  goods prices must be flexible and the exchange
  rate does not matter for competitiveness.

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Criterion 3 (McKinnon) Openness

• Depreciation makes exports less expensive and
  imports more expensive
• If countries are very open to trade, they tend to
  use a lot of imported goods in the production
  process
• Then, depreciation is ineffective
• Depreciation ? imports more expensive ? domestic
  prices rise.

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Criterion 4 Fiscal Transfers

• Countries that agree to compensate each other for
  adverse shocks form an OCA.
• Transfers can act as an insurance that mitigates
  the costs of an asymmetric shock.
• Transfers stimulate demand ? demand curve shifts
  back.
• Transfers exist within national borders
• implicitly through the welfare system (e.g.
  unemployment benefits)
• explicitly in federations.

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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.
• Different interest groups enjoy political power
  in different countries.

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Criterion 6 Solidarity vs Nationalism

• 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.

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A summary
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Is Europe An OCA?

• A synthetic OCA index how much countries adjust
  their XRs (vis-à-vis DM) in response to an
  asymmetric shock (based on past experience)?
• Source Bayoumi and Eichengreen (1997)

28
Symmetry of shocks

• Each point represents correlation between demand
  and supply shocks of particular country with the
  euro-zone average.
• Source Korhonen and Fidrmuc (2001)

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Is Europe An OCA?

• Asymmetric effects of monetary policy effects on
  GDP and prices of a 1-pt change in the interest
  rate.

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Openness
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Openness

• Most EU countries are very open.
• The McKinnon criterion is broadly satisfied.

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Diversification

• Trade dissimilarity index (vis-à-vis Germany)
• Source Bayoumi and Eichengreen (1997)
• Most EU countries have a diversified production
  structure (intra-industry trade dominates).
• The Kenen criterion is broadly satisfied for the
  euro-zone countries.

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Labour Mobility (1)

• Labour mobility is costly
• moving costs,
• risk of becoming unemployed in destination
  region/country,
• long-run career opportunities,
• family members job/education prospects,
• eligibility to welfare benefits,
• taxation,
• cultural/linguistic differences,
• national attachment (patriotism/nationalism).

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Labour Mobility (2)

• International labour mobility is low in Europe
• Foreign born population (percentage of
  population)
• Source OECD.

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Labour Mobility (2)

• Labour mobility is low in Europe even within
  countries.
• Internal migration (percentage of population)
• Source OECD.

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Labour Mobility (3)

• Low labour mobility implies that asymmetric
  shocks have highly persistent effect
• US employment shocks absorbed primarily through
  migration
• EU employment shocks translate primarily into
  lower participation
• Low labour mobility results in high long-term
  unemployment and low participation

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Inside the OCA Index Labour Mobility (3)
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Fiscal Transfers

• The EU does not satisfy the transfer criterion.
• The overall EU budget
• is low, capped at 1.27 of EU GDP
• entirely used for administration, CAP, regional
  and structural funds
• transfers aimed at redistributing income
• not at mutual insurance against shocks.

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Fiscal Transfers

• This contrasts with practice in federations
• Automatic stabilizers automatically
  redistribute income in response to shocks
• Prosperous regions pay higher income tax.
• Depressed regions get more unemployment benefits
• Federal entities often have explicit mechanisms
  for fiscal transfers
• US 1 fall in state GDP compensated by
  0.10-0.40 increase in net transfers

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Homogeneity of Preferences

• Little is known about this criterion.
• Macroeconomic policies differ considerably across
  Europe.
• So do political developments.

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Solidarity vs Nationalism

• Little is known about this criterion.
• Opinion polls suggest that there are differences
  in public attitudes towards the EU but these are
  not too great.
• Referendum outcomes
• Maastricht/Nice Treaties
• EU Accession
• Constitutional Treaty

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Solidarity vs Nationalism
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Overall

• OCA criteria glass is half full or half empty.

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History Never Ends The Endogeneity of OCA
Criteria

• Living in a monetary union may help fulfil the
  OCA criteria over time.
• Would the US be an OCA without a single common
  currency?
• Will the existence of the euro area change
  matters too?

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The Endogeneity of OCA Criteria Two views

• Optimistic view (Frankel and Rose, European
  Comission)
• Deepening trade integration ? intra-industry
  trade and spillovers effects ? greater symmetry
  of shocks ? OCA criteria more likely fulfilled
  once common currency introduced
• Pessimistic view (Krugman)
• Deepening trade integration ? greater
  specialization ? greater vulnerability to
  country-specific shocks
• No firm conclusion so far

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The Endogeneity of OCA Criteria Optimistic View
T
OCA
EU
Divergence
T
Trade integration
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The Endogeneity of OCA Criteria Pessimistic View
T
OCA
EU
Divergence
T
Trade integration
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Will Trade Deepen?

• 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
• estimates range from 50 per cent to 100 per cent
• the border effect literature provides similar
  estimates.
• EMU Preliminary evidence (Micco et al., 2003)
• Trade among EMU countries has increased by
  between 4 and 16 compared to other countries.

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EMU and Labour Markets

• Mobility may not change much, but wages could
  become less sticky.
• Two views
• the virtuous circle labour markets respond to
  enhanced competition by becoming more flexible
• the hardening view labour markets respond to
  enhanced competition by increasing protective
  measures that raise stickiness.
• The jury is still out.

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Are the Other Criteria Endogenous?

• Transfers
• currently no support for more taxes to finance
  transfers.
• Homogeneity of preferences
• no expectation that it will change soon.
• Solidarity vs nationalism
• no expectation that it will change soon.

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UK and EMU membership

• UK negotiated a formal opt-out from the
  obligation to pursue EMU membership
• UK policy set out in 1997
• UK committed in principle to join the EMU
• But would only join if there is a clear and
  unambiguous economic case for joining
• To assess whether there is such a case, the
  Treasury devised 5 economic tests
• If all 5 tests are passed, the final decision is
  to be made by the British people in a referendum

52
UK Treasurys Five Economic Tests

• 1. Convergence in business cycles and economic
  structures There has been convergence but not
  yet enough, and important differences remain,
  especially in the housing market ? euro-area
  interest rates unlikely to be optimal for the UK.
  ?
• 2. Flexibility if problems emerge UK labor
  market is more flexible than others, but still
  not sufficiently so. ?
• 3. Investment UK membership in the euro-zone
  would boost FDI inflows to the UK. ?

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UK Treasurys Five Economic Test

• 4. Financial Service and the City Euro-zone
  membership would strengthen the competitive
  position of the City. ?
• 5. Growth, stability and employment Joining the
  EMU would allow the UK to benefit through
  increased trade, investment, competition (? lower
  prices) and productivity growth. ?
• Treasurys proposal Joining now would not be in
  the national economic interest.
• Source HM Treasury, UK membership of the single
  currency An assessment of the five economic
  tests, June 2003.

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In the End

• 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 tell us where the costs will
  arise
• labour markets and unemployment
• political tensions in presence of deep asymmetric
  shocks.