EXCHANGE RATE - CONCEPTS, REGIMES, CRISIS AND FUTURE

Optimal Currency Area: Is Eurozone an Optimal

Currency Area?
Critical analysis in the light of Greece and in general, the problems faced by Southern Europe.
How did the United States become an Optimal Currency Area?

Group 3
Mehta Akshay 2014PGPM30
Natasha Gautam 2014PGPM034
Neha Beck 2014PGPM35
Trishul Shetty 2014PGPM58
Vivek Kashyap 2014PGPM65

Acknowledgement
We would like to thank Indian Institute of Management, Indore, for giving us the resources to do
effective research through online databases, research papers and journals. We are also very much
grateful to our professor, Venkatraman Anantha Nageswaran, for hand-holding us through-out the
entire course and also providing a comprehensive understanding of the topic.
Finally we thank all our friends and institute staff for helping us with all the nitty-gritty of doing the
necessary research required to finish this report.
Thank you.

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Abstract
This paper begins with the discussion on Mundell's theory of optimum currency areas. Then we move
forward to establish the various economic criteria for implementing a common currency on the basis
of Krugmans & Obstfelds work. Furthermore, we evaluate the Eurozone against these criteria
highlighting Greece and the problems faced by Southern Europe in general. Eurozone is not found to
be an optimum currency area. However, the decision of economic integration of Eurozone was more
influenced by political philosophy and its implementation has fulfilled the underlined goal up to
certain levels (which is not part of this paper). After this we close this paper with an analysis on United
States as an optimal currency area.

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Table of Contents
Optimal Currency Area ...................................................................................................................... 5
Mundell's theory of optimum currency areas .................................................................................... 5
Evaluation of Eurozone as an OCA ..................................................................................................... 6
United States of America Optimal Currency area?.......................................................................... 8

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Optimal Currency Area

Optimal Currency Area (OCA) is a region where, having entire region sharing single currency
can maximize economic efficiency as compared to having individual national currencies. The
concept of OCA was first pioneered by Robert Mundell in 1961 in his article A Theory of
Optimum Currency Areas1 which will be discussed in detail further.

Mundell's theory of optimum currency areas

Mundell defined OCA as the domain within which exchange rates are fixed.1 Consider a
Nation where exchange rate between different regions of that nation is fixed i.e. the currency.
However Mundell argued that OCA is not a nation but a region which may consist different
countries. He defined this region which is characterized by absolute internal mobility of
factors and external immobility of factors. 1 In laymans language; the region must have high
degree of mobility of factors such as labour, capital flow, etc.
Mundell's theory aims to answer the question we all have been lately thinking about, "What
is the criteria for an optimum currency area?
To bring light to this question, Mundell created a cost-benefit analysis of the monetary union.
The benefits are as follow:
1. Decrease in various transaction costs which exist due to the presence of numerous
currencies
2. Gain in liquidity of the currency with increase in area of transactions - thus all financial
markets also benefit
Costs:
1. Loss in monetary policy autonomy
2. Asymmetrical shocks no longer absorbed
Asymmetrical Shock: When there exists an imbalance of trade between two countries with
different currencies and a floating exchange rate, this imbalance/asymmetrical shock could
be absorbed by a change in the exchange rate. For example, due to this imbalance Country A
faces unemployment (demand for its products decreasing) and Country B faces inflation
(demand for its products increasing), in such a scenario Country A could decrease its interest
rates to tackle unemployment, while Country B could raise its interest rates to tackle inflation.
Country a currency would depreciate against that of Country B, and balance would be
restored at a lower adjustment cost compared to if the two regions had a common currency.
Now let us look what happens when there exists a common currency between the two
countries and imbalance of trade occurs. The central bank is then faced with a dilemma to
either help Country A with its unemployment or Country B with its inflation. This can be
1

R. Mundell (1961): A Theory of Optimum Currency Areas, in: The American Economic Review

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resolved if mobility of factors of production exists, so if capital and labour move from area of
deficit demand to area of surplus demand, stability of employment and prices can be
achieved.
Another definition of OCA as defined by Krugman and Obstfeld is groups of regions with
economies closely linked by trade in goods and services and by factor mobility2
In order to evaluate whether a region is OCA or not we need some criterias. We have
adopted this criterias from Krugmans & Obstfelds case study on is Europe as OCA. 3 This
criterias are also similar to Mundells criteria for OCA.
This brings us to the following main criteria:
1. Extend of Intra-regional trade
2. Labour & Capital Mobility
3. Similarity of Economic structure
4. Fiscal Federalism
Therefore, "the more open the economy, the more sensitive it will be to shocks and the less
stable and liquid its currency will be. It follows that for an open, diversified economy, the
benefits of joining a monetary union in terms of gains in liquidity and financial stability can
offset the additional adjustment costs that could result from its joining the union." (Alexandre
Swoboda, 1999)

Evaluation of Eurozone as an OCA

One of the crucial question that arises while evaluating Europe as an OCA is whether Eurozone
satisfy the four basic criterias of being an OCA.
1. Intra-regional trade:
The first criteria for evaluation of OCA is level of the intra-regional trade between the partner
countries. Integration in the economies of partner countries is one of the pre requisites in
order to enjoy the benefits of currency union.
Intra-regional trade combined with common currency boosts up the level of economic
activities between the partner countries. In case of EMU countries their Intra-EMU trade was
10 to 20% of their total international trade. This figures are significant and support Eurozone
as an OCA. Comparatively the level of intra-regional trade in USA is significantly higher which
is due to geographical vastness of USA.

P. Krugman, M. Obstfeld (2009): Optimum Currency Areas and the European Experience, in:
International economics: theory & policy, Boston, Mass.: Pearson, Addison-Wesley
3
Compare: P. Krugman, M. Obstfeld (2009): Case Study: Is Europe an Optimum Currency Area?, in:
International economics: theory & policy, Boston, Mass.: Pearson, Addison-Wesley

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2. Capital & labour Mobility:

Another major OCA criteria is labour and capital mobility. Movement of labour & capital
between partner countries of OCA can enable the countries to overcome the variability of
demand & supply of labour and capital, hence absorb the asymmetrical economic shocks. If
the demand of labour & capital in one country is significantly higher and the supply at another
member country is also higher. Mobility of labour & capital reduce unemployment, create
new opportunities and strengthen the economy.
In 1993 EU brought in the concept of single market which allowed free movement of goods,
services, capital & people. Despite of all this initiatives national borders served as major
barriers to labour mobility. Unlike USA there are substantial differences in the language,
cultures & social security, discouraging the free movement of labour between the member
countries. Hence the unemployment increases during product market disturbances and low
labour mobility doesnt enable the member countries to absorb the asymmetrical economic
shocks. Therefore labour & Capital mobility was not a good indicator to form the EMU.
3. Similarity of Economic Structure:
One of the vital criteria in evaluation of OCA is the similarity of economic structure between
the member countries. In another words convergence of business cycle between the member
countries is very essential for implementation of common currency. Common currency
implies that the member countries should implement similar or highly synchronized monetary
policies to maintain the currency peg (Common currency is ultimate level of currency
pegging). If different member countries are facing booms & recession simultaneously, aligning
the monetary policy in such scenario will hurt either of the member countries economy.
EMU members have very similar industrial & manufacturing structure and have very high
volumes of intra-industry trade. But there are vital differences in the economic structure of
northern & southern Europe. North is usually highly equipped characterized by skilled labour,
capital & high quality productivity whereas south is usually characterized by less innovative,
specialized manufacturing structure, less capitalized and lack of qualified labour resulting in
significant differences in economic structures. One of the reasons for Greece crisis is the
dissimilarity of Greeces economic structure to EMU. Hence it has to follow monetary policy
which is aligned to EMU i.e. low interest rate and stronger currency. On the other hand its
economy faces recession, negligible capital inflow, and huge debts resulting in fiscal policies
which doesnt align to the monetary policies of EMU further worsening the situation.
The differences in the economic structure of northern & southern Europe has adversely
affected the southern European economies. Northern economies are well of and usually
booming compared to southern countries. The monetary policies of the EMU are usually
aligned to Northern region (Germany) and the southern economies have to follow monetary
policies which are usually not aligned to their economic structure. Also the Labour and Capital
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flow between EMU members is low which adds to their adversity due to increasing
unemployment and asymmetrical shocks.4
4. Fiscal Federalism:
Fiscal Federalism refers to transfer of economic resources from wealthy economies to
economically backward countries which can restore economic stability within the OCA. For
example whenever a particular state in US faces economic problems it receives economic
support from authorities in Washington D.C. This includes welfare benefits or federal transfer
payments to mitigate the losses due to economic instability in some regions.
In case of EMU, Nations doesnt have any liability of other member countries. Only 1% of total
GDP of all the member country is available to EMUs disposal to rescue the economically
suffering member economies. This is one of the other factor that added to Greeces crisis
since they cannot receive any reserves to revive their economy.
On the basis of above Evaluation of EMU it is evident that EMU is rated moderately high on
inter-regional trade and low on other three criterias. Hence we can conclude that EMU was
not an optimum currency Area. We can also conclude that Euro is not an optimal currency
viewing to the problems faced by southern Europe and the Greeces crisis. But the European
integration decision was more influenced by the political philosophy rather than the
economic theories. Eurozone has increased trade between member economies by minimum
8% and up to 23% post EMU currency integration. The underlining rationale behind formation
of Euro has been fulfilled up to certain extents, but that is not part of this paper.

United States of America Optimal Currency area?

A popular belief among the economists and the writers is that the Eurozone crisis was
inevitable as it is not an optimal currency area. Lack of fiscal institutions to absorb the varying
impact of business cycles on different parts of Europe was always going to be a factor. The
institutions that did exist did not have enough power to adjust its policies for a relatively hard
hit area compared to a milder hit area. However the same cannot be said about the United
States. The federal government transfers across states fill in the gaps left by the common
monetary policy. States that are struggling more receive more in transfers from the federal
government, which prevents, say, California from suffering from a dramatically worse
Milovan Rankov(2013): Optimum Currency Area Criteria in the Greece published in
Eurasian Journal of Economics and Finance, 1(1), 2013, 25-34
4

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recession than the rest of the country, of the sort that would generate Greece-like
complications.
Other major factor that contributes to the success of common currency in the US is the
thinness of its state borders. By thinness we mean cultural differences, language barriers,
educational system, and mind-set of the people. The differences across American states, in
terms of language and culture, are far smaller than those between European nations. It is not
that the whole country has people with a similar culture but the division is pretty much
identical across most of the states. English is by far the language of choice (unlike Europe),
the television programmes are the same, the structure of the educational system is basically
the same and the government is run along the same lines with same rules.5
United States is considered as a nation state. Not just in decision making of the government
but it is also visible amongst peoples opinion. A Californian would be willing to help someone
from Pennsylvania but the same cannot be said about the European countries.
However this is only a modern happening. For much of United States history, one wouldnt
consider it as an optimal currency area. In a 2000 paper for the National Bureau of Economic
Research, Hugh Rockoff argued that until the 1930s, the United States might well have been
better off if each region had had its own currency, since shocks to agricultural or financial
markets hit different regions and their banks differently. Often, an interregional debate over
monetary institutions would follow, he wrote. The uncertainty created by the debate would
further aggravate the contraction.
So does that mean in modern history the United States has not observed any asymmetric
shocks? Not really. Florida, for example, can experience a housing bust even as the timber
markets of the Pacific Northwest remain relatively robust. Florida cant devalue its currency
to stimulate exports, and yet nobody was talking about the threat to the dollar zone from a
potential Floridas exit back in 2010.
McNamara maintains that the difference is less technical than political. People think about
the United States as a nation-state, she said. People dont know how to think about the
[European Union]. Throughout the entire euro zone crisis, traders, financial actors, have
been kind of casting around to figure out, How tightly bound together is the EU as a political
entity? Can we really count on the other members bailing out Greece?
So the reasons for Euro zone crisis seems more obvious. Euro zone cannot be an optimal
currency area as long as the unwillingness to help exists. If people in Europe will continue
asking questions like why should Germany which has been doing well as country help out
Greece, who are in this mess due to their own doing. Why should these countries help out
the PIGS nations? Shouldnt they sort out their own mess? The uncertainty has lingered for
five years as voters in the euro zones richer core, most notably in Germany, have signalled an
unwillingness to help Greece pay its debts. Howevwe the situation in the United States is quite
different. There is no ifs and buts here. The US have come up with large institutions since the

R.A.(2010): Americas Euro, published in The Economist

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1930s to automatically transfer the money to states in distress so they can be pulled back into
the same economic cycle by simply pumping in more money.
Paul Krugman explained three years ago in regard to Florida:
America may have a small welfare state by European standards, but its still pretty big, with
large spending in particular on Social Security and Medicareobviously both a big deal in
Florida. These programs are, however, paid for at a national level. What this means is that if
Florida suffers an asymmetric adverse shock, it will receive an automatic compensating
transfer from the rest of the country: it pays less into the national budget, but this has no
impact on the benefits it receives, and may even increase its benefits if they come from
programs like unemployment benefits, food stamps, and Medicaid that expand in the face of
economic distress.
For all of the United States problems, we still are a federal nation-state. Nobody doubts
that, McNamara said. 6

Intra-regional trade
Mobility of capital and labour
Similarity
of
Economic
(Convergence in Business Cycle)
Fiscal Federalism

U.S.A
High
High
structure Low
High

Euro-Zone
moderate
Moderate
Low
Low

Once we compare the United States to the Eurozone, it is obvious to us that The European
union is definitely not an OCA. Even the constituent nations dont know what to expect from
this meeting.

KATHY GILSINAN(Jun 30, 2015): What Is the European Union, Exactly? Published in The Atlantic

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