While adopting a common currency is ultimately a political decision, these results imply that the broadest of these areas, the UK, is the optimal currency area in the sense of minimizing transactions costs. We do find differences in the UK less Scotland
Scotland
Scotland is a country that is part of the United Kingdom. It covers the northern third of the island of Great Britain, with a border with England to the southeast, and is surrounded by the Atlantic Ocean to the north and west, the North Sea to the northeast, the Irish Sea to the south, and more th…
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What countries would struggle to maintain international competitiveness without the currency area?
There are many examples of countries within Europe that would struggle to maintain international competitiveness without the currency area. The areas of the EU with low labour mobility are furthest away from meeting the criteria of a currency area. However, while the removal of legal barriers (such as visas) has improved this labour mobility, issues such as language barriers remain, for example, a French worker may not wish to move to Spain because they cannot speak Spanish, also people tend to have ties to the places they currently live and may not be willing to move away from them. Bayoumi and Eichengreen (1992) compared the US and Europe with respect to how disturbances in separate regions match shocks in a selected benchmark region. They chose Germany as the benchmark for Europe and found that there is a relatively high symmetry of disturbances within the core of the EU such as Austria, Benelux, Denmark, France and Germany. They also found that the symmetry was lower for western European countries. When compared to the USA, the EMU had a higher probability of asymmetric shocks. However according to Fidrmuc and Korhonen (2001) the extent of the asymmetric shocks is declining in the EU economies. Bayoumi and Eichengreen believe that countries within Europe are further from an OCA than regions in the USA, and so are less appropriate as a currency area. These studies suggest that two countries in the EU are less suited to forming a monetary union than the regions of the USA, although the situation is improving. Frankel and Rose (1998) argued that the higher the trade integration, the higher the correlation of the business cycles among countries, in other words there is greater symmetry of shocks. They also propose that business cycles and trade integration are inter-related and endogenous processes to establishing a currency union. Frankel and Rose’s empirical findings noted that EMU entry encourages trade linkages among countries and causes the business cycle to be more symmetrical among the union’s participants. Rose and Stanley (2005) find that a common currency generally increases trade among its members between 30% and 90%. These findings agree with Mundell’s argument that a common currency can help to deal with asymmetrical shocks. Frankel and Rose’s findings suggest that although two countries considering creating a common currency may not meet the criteria before they join the currency area they may do afterwards.
What is the OCA of a country?
The first of the criteria for an OCA is price and wage flexibility throughout the geographical area. This means that the market forces of supply and demand automatically distribute money and goods to where they are needed. For example, with regards to France and Germany under perfect wage flexibility, the unemployed workers in France will reduce their wage claims, and conversely excess demand for labour in Germany will push up the wage rate. This inevitably shifts aggregate supply for France outwards making French products more competitive, and stimulating demand, whereas the opposite occurs for Germany. 2 below shows the effect of wage flexibility as an automatic adjustment mechanism.
What happens if cancer has a bad crop?
Under a common “world” currency if Cancer has a bad crop the total amount of world currency will exchange for full quantity of crop, irrespective of who holds the money as competition and freedom of arbitrage assures a single price. So long as competition exists, and there are no time lags in the transmission of goods or information, the price of the food will rise for both countries and so the burden of shock is shared automatically and equally by the two countries.
What does Mundell's argument agree with?
These findings agree with Mundell’s argument that a common currency can help to deal with asymmetrical shocks. Frankel and Rose’s findings suggest that although two countries considering creating a common currency may not meet the criteria before they join the currency area they may do afterwards.
What would happen if wage flexibility and labour mobility did not exist?
Therefore if wage flexibility and labour mobility does not exist then the adjustment process will be entirely reliant on inflation in Germany. Mundell stated product diversification over the geographical area is an important determinant of the suitability for a region to share a currency.
What is the importance of factor mobility?
Mundell cited the importance of factor mobility as an “essential ingredient of a common currency” (Mundell, 1961) and thus labour mobility across the geographical region is one of Mundell’s main criteria for an OCA. In the case of De Grauwe’s example, French unemployed workers would move to Germany where there is excess demand for labour. This free movement of labour eliminates the need to let wages decline in France and increase in Germany solving both the unemployment problem in France, and the inflationary wage pressures in Germany.
What is the existence of labour mobility?
The existence of labour mobility relies on the unrealistic assumptions of free movement of workers between regions regardless of physical barriers such as work permits, cultural barriers such as language difficulties and institutional barriers such as superannuation transferrals. Indeed Peter Kenen referred to the additional costs of retraining workers and there is an “unrealistic assumption of perfect occupational mobility“ (Kenen, 1969). Ronald McKinnon observed that “in practice this does not work perfectly as there is no true wage flexibility” (McKinnon, 1979). McKinnon is simply highlighting the point that in reality wage flexibility, as well as perfect labour and capital mobility do not always exist. Considering a case where wages in France do not decline despite the unemployment situation (no wage flexibility), and French workers do not move to Germany (no labour mobility) both Germany and France would be stuck in the original position of disequilibrium. In Germany the excess demand for labour would put pressure on the wage rate, causing an upward shift in the supply curve. The adjustment from the position of disequilibrium would in this case come exclusively from price increases in Germany making French goods more competitive once more. Therefore if wage flexibility and labour mobility does not exist then the adjustment process will be entirely reliant on inflation in Germany.
Published Versions
Silvo Borger and Berber Grubel eds, The European Community after 1992, Perspectives from the Outside, London: Macmillan, 1992.
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What Is Optimum Currency Area (OCA) Theory?
Optimum currency area theory (OCA) states that specific areas not bounded by national borders would benefit from a common currency. In other words, geographic regions may be better off using the same currency instead of each country within that geographic region using its own currency.
What is OCA theory?
OCA theory posits that implementing currencies by geographic and geopolitical region, instead of by country, leads to greater economic efficiency. An OCA must meet four criteria to qualify, and some economists suggest a fifth.
How does sharing a currency benefit a geographic region?
Sharing a currency can benefit a geographic region by significantly increasing trade. However, this trade must outweigh the costs of each country giving up a national currency as an instrument to adjust monetary policy. Areas using OCA theory can still maintain a flexible exchange rate system with the rest of the world.
Why is the labor force not fluid in the Eurozone?
Also, due to language, culture, and distance difficulties, the labor force in the eurozone is not fluid or mobile. Wages are not uniform across the geopolitical area, either. 4
Which economist suggested the adding of a fifth criterion of production diversification within the geopolitical area?
1. Princeton professor and international economist Peter Kenen suggested the adding of a fifth criterion of production diversification within the geopolitical area. 2.
What is the purpose of flexibility in pricing and wages?
The flexibility of pricing and wages, along with the mobility of capital, to eliminate regional trade imbalances.
Who developed the OCA theory?
OCA theory was developed in 1961 by Canadian economist Robert Mundell based on earlier work by Abba Lerner. It speculates that there is an optimum geopolitical area that should share a currency, but this geopolitical area doesn’t necessarily correspond with national borders. An optimum currency area could be several nations, ...
What is an optimum currency area?
Optimum currency area, a currency area in which the benefits of using a common currency outweigh the costs of individual economies’ giving up their own currencies. Economies form a currency area if they use the same legal tender or have their exchange rates irrevocably fixed. An optimum currency.
What is the new theory of optimum currency areas?
It explores, for instance, whether economic structures converge or diverge owing to intensified trade and increasing competition that comes with more price transparency. In theory, this could give rise to a paradox: if the member economies become more specialized and thus more susceptible to asymmetric shocks, a currency union that satisfied the OCA criteria prior the union’s creation may then become suboptimal for the very reason that it has been formed.
What is the currency of a country?
currency, in industrialized nations, portion of the national money supply, consisting of bank notes and government-issued paper money and coins, that does not require endorsement in serving as a medium of exchange; among less developed societies, currency encompasses a wide diversity of items (e.g.,livestock, stone carvings, tobacco) used as…
What happens when a currency area suffers more from unemployment or inflation?
Whenever a member of the currency area suffers more from unemploymentor inflationas a consequence of a shock, those market mechanisms or government policies would replace exchange-rate changes that otherwise could have led to rising employment (devaluation) or the easing of pricepressures (revaluation).
What is the meaning of "floating" in exchange rates?
An exchange rate is “floating” when supply and demand…. monetary union. Monetary union, agreement between two or more states creating a single currency area. A monetary union involves the irrevocable fixation of the exchange rates of the national currencies existing before the formation of a monetary union.
What is the meaning of exchange rate?
exchange rate, the price of a country’s money in relation to another country’s money. An exchange rate is “fixed” when countries use gold or another agreed-upon standard, and each currency is worth a specific measure of the metal or other standard. An exchange rate is “floating” when supply and demand…
Is the exchange rate a reliable adjustment instrument?
First, modern conceptualizations of the exchange rate raised doubts in regard to the effectiveness of the exchange rate as a reliable and effective adjustment instrument. In fact, the occurrence of self-fulfilling currency attacks implied that there was no such thing as an irrevocably fixed exchange rate.
Why is the formation of an optimum currency area important?
Seventhly, the formation of an optimum currency area saves the cost of official intervention in foreign exchange markets involving the currencies of member countries, cost of exchanging one currency into another and the cost of hedging.
What is the optimum currency area?
According to Mundell, optimum currency area is a region which leads automatically to a complete elimination of unemployment and the BOP disequilibrium. In a currency area, either there is a common currency or the currencies of a group of countries are linked through a permanently fixed exchange rate.
What are the disadvantages of the optimum currency area?
Firstly, each member nation cannot pursue independent stabilisation, growth and other policies which it deems appropriate in its special conditions.
How does single currency help Europe?
First, single currency will facilitate smooth and enlarged volume of trade and investment within Europe. Second, the single stable and strong currency will give a greater voice to Europe in the global economy. Third, it will speed up the process of political integration of Europe. International Economics, Foreign Exchange, Optimum Currency Areas.
Why is the currency area important?
Firstly, the formation of a currency area eliminates the uncertainty that often results from flexible or continuously changing exchange rates.
What are the benefits of currency union?
The benefits from the formation of currency union include gains from resource saving in the field of banking and foreign exchange dealings, gains from resource reallocation arising mainly from the pooling of reserves, gains from increased trade and reduced uncertainty and gains from the efficient functioning of the monetary mechanism.
When did Magnifico and Fleming agree that countries with similar propensities to inflation should form currency areas?
Magnifico (August 1971) and Fleming (September 1971) agreed that the countries with similar propensities to inflation should form currency areas. If different countries have different Phillips type inflation-unemployment trade off, the formation of a currency area by them is not feasible.
Abstract
The purpose of this paper is to determine if the Euro zone is an optimal currency area. It involves inspecting existing related literature and data for certain prerequisites set out by the Optimum Currency Area theory.
Introduction
In 1979, the European Commission established the European Monetary System (EMS) arrangement, involving a large number of countries who were part of the European Economic Community (EEC) fixing their exchange rates based on a unity known as the European Currency Unit (ECU).
Related Literature
This section includes a review of the related literature on the Optimum Currency Area theory.
Cite This Work
UKEssays. (November 2018). Is the Eurozone an Optimal Currency Area?. Retrieved from https://www.ukessays.com/essays/economics%20/eurozone-optimal-currency-area-1020.php?vref=1
What Is Optimum Currency Area (OCA) Theory?
Understanding Optimum Currency Area (OCA) Theory
- Sharing a currency can benefit a geographic region by significantly increasing trade. However, this trade must outweigh the costs of each country giving up a national currency as an instrument to adjust monetary policy. Areas using OCA theory can still maintain a flexible exchange rate system with the rest of the world. OCA theory was developed in 1961 by Canadian economist R…
Special Considerations
- Some economists argue that the United States should be divided into several smaller currency areas, as the country as a whole does not fit the criteria listed in Mundell’s original OCA theory. Economists have calculated that the Southeast and Southwest regions of the United States do not necessarily fit with the rest of the country as an OCA.3
Optimum Currency Area Theory Example
- Many point to the euro as proof of OCA theory in action. However, some argue that the area did not meet the four criteria as laid out by Mundell’s theory at the time of the euro's creation in 1999. This lack of meeting the requirements, they say, is the reason the eurozonehas struggled since its inception. Indeed, the OCA theory was put to the test in 2010 as sovereign debt issues faced by …