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. The outcome is that the Euro zone is not an optimal currency area, despite major improvements seen following the introduction of the Euro in the areas including .... etc . Meanwhile, the prerequisites of ..... etc are not met.
I. Introduction 简介
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). Following this event, discussions over the possibility of the Euro zone being an Optimal Currency Area emerged. In January 1999, the European Union introduced the Euro as it's common currency, the Euro. Initially, the euro served its purpose as an electronic currency utilised by banks. In January 2002, the Euro was introduced as banknotes and utilised as a legal tender for all transactions in 12 countries including Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.
The rest of the dissertation is structured in the following format.
Section II includes a description of the theory of Optimum Currency Area which was the workings of Robert Mundell in the early 1960s. In Section III covers related literature on the subject as well as empirical
This section includes a review of the related literature on the Optimum Currency Area theory.
Mundell (1961) published his work on the theory of optimum currency areas, which focused geographical regions that was that would benefit from a single monetary policy under a common currency or definitely pegged exchange rates. This was to counter Friedman (1953)'s argument that strictly flexible exchange rates enabled corrective changes required to bring about external equilibrium.
In order to determine whether a geographical region was an optimal currency area, Mundell (1961) studied the mobility of factors, in particular labour, as the main perquisite. In an currency which has the characteristics of high mobility of labour and other factors products, there is a high probability that the need for altering the real factor prices is likely to be lower. High Labour mobility implies that workers have the flexibility of moving to different counties, which have more desirable demand conditions in order to reduce unemployment in their home country. Meanwhile, wage flexibility implies that an adjustment in the real exchange rate in the event of asymmetric shock can come about from wage adjustments as wages are the most important component of costs, therefore prices.
Later on, several other factors were taken into consideration. McKinnon (1963) argued that the more a country is in involved in international trade, the benefits it is likely to experience, here depreciation would have lesser effect in rebalancing a country's external deficit. Kenen (1969) debated that a well diversified economy was a criteria of optimum currency area perquisites. In this case, the economy can adjust relatively well by absorbing sector-specific shocks thought shifting production within the internal economy. Meanwhile, Fleming (1971) believed that similarity of inflation rates should be a one of the perquisites to determine an OCA region as this will help maintain balanced current -accounts in other counters in the monetary union.
During the 1990s, future of European single currency was the hot debate (Tavlas, 1994). (Bayoumi and Eichengreen, 1993a) find that asymmetrical shocks was more conspicuous in Europe when compared to states in US, but there was findings of smaller and more correlated shocks between
The benefits of a common currency are all microeconomic in nature relate to lower transaction costs, more transparency and less risk.
The costs of a common currency are all macroeconomic n nature and relate to the loss of independent monetary policy andd exchange rate adjustment in the face of asymmetric shocks.
(1) Price & Wage Flexibility
Consider the EMU and suppose Italy is hit by an asymmetric shock increasing
unemployment in Italy but nowhere else. Adjustment must come through relative prices in
the member countries such that Italy becomes more competitive and unemployment
decreases. Because the exchange rate is fixed, adjustment has to take place in goods prices.
Since wages are the most important component of costs (and thus prices), an adjustment
in the real exchange rate can come about through wage adjustments. Flexibility in wages
are thus desirable for a common currency.
(2) Mobility of factors of production including Labour
Fiscal Integration: If the currency union meet the criteria of imposing fiscal transfer system, the need to alter exchange rate caused by asymmetric shocks is significantly reduced due the fiscal transfer system aiding the country affected by the shock.
Trade openness: In open economies, the exchange rate as policy instrument is not very effective for adjusting shocks, especially in small open countries where total consumption of goods and services is made up of large component of imported goods and services from other countries.
Diversification in production and consumption:
Before the European Union founded it's monetary area with common currency, questions such as whether the eurozone can be classed as a optimum currency area and whether the judgement to consolidate the European Union member states under common currency was in fact the correct decision. Following the recent monetary crisis,
Benefits of a common currency
One of benefit of a common currency is the elimination of transaction costs, this removes the deadweight loss to society.
Another benefit is increased price transparency. Prices can be compared more easily across countries which shoulder foster competition and reduce price differences between countries.
Another benefit is reduced uncertainty, removing uncertainty about future exchange rates leads to welfare gains.
International Currency, join currency may play more important role in the global econoy, Better funding and more liquid.
Costs of common Currency
The main costs associated with a common currency is that member countries are more likely to suffer from asymmetric shocks. Suppose that a country gets hit by a shock that increases unemployment in that country but does not affect the other member countries, in a currency union, the country cannot devalue its exchange rate to dvalue its exchange rate to join competitiveness because the exchange rate is fixed. In addition, the country cannot relax its monetarypolicy to boost economiy because monetary policy is no longer independent,. Hence the ability to deal amcroeconomics shocks is greatly limited for inidividual countries. Adjustment must come throuh other channels which define a "optimal currency area".
The Theory of Optimal Currency Area
The theory of Optimal Currency Area was introduced by Robert Mundell in 1961.
Related Literature & Empirical Evidence.
Robert Mundell (1961) popularised topic of Optimum Currency Area to apply to the a geographic region that potentially could benefit from one monetary policy in a common currency or pegged interest rate.
More specifically, Muindell (1961) looked into the mobility of factors, paying extra attention to labour. Geographic labour mobility enabled
Several factors...In the next few years, new factors were taken under consideration. McKinno (1963)
Kenen (1969) argued that monetary unions would better suit countries with diversified economies, as demand or supply shocks that affected one sector could be more easily compensated by the others.