Transcript Is Europe an Optimum Currency Area?

Robert Mundell
The Bank of Sweden
Prize in Economic
Sciences in Memory
of Alfred Nobel 1999
“for his analysis of
monetary and fiscal
policy under different
exchange rate regimes
and his analysis of
optimum currency
areas”
Mundell
American Economic Review 1961
From Press Release - The Sveriges Riksbank (Bank of Sweden)
Prize in Economic Sciences in Memory of Alfred Nobel
• As already indicated, fixed exchange rates predominated in the
early 1960s. A few researchers did in fact discuss the advantages
and disadvantages of a floating exchange rate. But a national
currency was considered a must. The question Mundell posed
in his article on "optimum currency areas" (1961) therefore
seemed radical: when is it advantageous for a number of
regions to relinquish their monetary sovereignty in favor of a
common currency?
• Mundell's article briefly mentions the advantages of a common
currency, such as lower transaction costs in trade and less
uncertainty about relative prices.
• The disadvantages are described in greater detail. The major
drawback is the difficulty of maintaining employment when
changes in demand or other "asymmetric shocks" require a
reduction in real wages in a particular region. Mundell
emphasized the importance of high labor mobility in order to
offset such disturbances.
• He characterized an optimum currency area as a set of regions
among which the propensity to migrate is high enough to
ensure full employment when one of the regions faces an
asymmetric shock. Other researchers extended the theory and
identified additional criteria, such as capital mobility, regional
specialization and a common tax and transfer system. The way
Mundell originally formulated the problem has nevertheless
continued to influence generations of economists.
• Mundell's considerations, several decades ago, seem highly
relevant today. Due to increasingly higher capital mobility in
the world economy, regimes with a temporarily fixed, but
adjustable, exchange rate have become more fragile; such
regimes are also being called into question. Many observers
view a currency union or a floating exchange rate - the two
cases Mundell's article dealt with - as the most relevant
alternatives.
• Needless to say, Mundell's analysis has also attracted attention
in connection with the common European currency. Researchers
who have examined the economic advantages and
disadvantages of EMU have adopted the idea of an optimum
currency area as an obvious starting point. Indeed, one of the
key issues in this context is labor mobility in response to
asymmetric shocks.
Sources of benefits
•Less transactions costs
•Price transparency
•Less uncertainty
• Benefits of an international
currency
Less transactions costs
•Elimination of exchange
markets within union eliminates
cost of exchanging one currency
into another
• Cost reductions amounts to
0.25 to 0.5% of GDP (according
to European Commission)
• Fulls cost reduction only
achieved when payments
systems are fully integrated
Price transparency
•One common unit of account
facilitates price comparisons
•Consumer “shop around”
more
•Competition increases
•Prices decline and consumers
gain
Less exchange risk
•Euro eliminates exchange risk.
Exchange rate uncertainty
and the price mechanism
•Large exchange variability reduces
the quality of price signals in
allocating resources
•Example: large overvaluation of
dollar in 1980s led to decline of export
sector; a decline that turned out to be
unnecessary once the dollar declined
again.
•These large real exchange rate cycles
lead to large adjustment costs
Benefits of an international
currency
•International use of the dollar creates
seigniorage gains for the US
•Similarly, if euro becomes an
international currency, seigniorage
gains will follow for Euroland
•These gains, however, remain
relatively small; in the case of the US:
less than 0.5% of GDP per year
Benefits of monetary union and openness
Benefits of monetary
union are likely to be
larger for relatively open
economies
Benefits
(% of GDP)
In absence of monetary
union, transactions costs
and exchange risk are
larger for firms in very
open economies
Monetary union will be
more beneficial for firms
in very open economies
Upward sloping benefit
line
Trade (% of GDP)
The Theory of
Optimum Currency Areas
• Economic Integration and the Benefits of a
Fixed Exchange Rate Area: GG Schedule
– Monetary efficiency gain
• The joiner’s saving from avoiding the uncertainty,
confusion, and calculation and transaction costs that arise
when exchange rates float.
• It is higher, the higher the degree of economic integration
between the joining country and the fixed exchange rate
area.
– GG schedule
• It shows how the potential gain of a country from joining
the euro zone depends on its trading link with that region.
• It slopes upward.
The Theory of
Optimum Currency Areas
Costs
De Grauwe Chapter 1
The Theory of
Optimum Currency Areas
• Economic Integration and the Costs of a Fixed
Exchange Rate Area: The LL Schedule
– Economic stability loss
• The economic stability loss that arises because a country that
joins an exchange rate area gives up its ability to use the
exchange rate and monetary policy for the purpose of
stabilizing output and employment.
• It is lower, the higher the degree of economic integration
between a country and the fixed exchange rate area that it joins.
– LL schedule
• It shows the relationship of the country’s economic stability
loss from joining.
• It slopes downward.
The Theory of
Optimum Currency Areas
The Theory of
Optimum Currency Areas
• The Decision to Join a Currency Area: Putting
the GG and LL Schedules Together
– The intersection of GG and LL
• Determines a critical level of economic integration
between a fixed exchange rate area and a country
• Shows how a country should decide whether to fix its
currency’s exchange rate against the euro
The Theory of
Optimum Currency Areas
• What Is an Optimum Currency Area?
– It is a region where it is best (optimal) to have a
single currency.
– Optimality depends on degree of economic
integration:
• Trade in goods and services
• Factor mobility
– A fixed exchange rate area will best serve the
economic interests of each of its members if the
degree of output and factor trade among them is
high.
The Theory of
Optimum Currency Areas
The Theory of
Optimum Currency Areas
• Is Europe an Optimum Currency Area?
– What do the data tell us?
The Theory of
Optimum Currency Areas
Miles & Scott/Macroeconomics: Understanding the Wealth of Nations
Chapter 20, Figure 20-03
FIGURE 20-3 Importance of EU trade for EU countries, 1998.
The Theory of
Optimum Currency Areas
GDP correlation
• Correlation with EU GDP
(Figure continues on next 2 slides)
Miles & Scott/Macroeconomics: Understanding the Wealth of Nations
Chapter 20, Figure 20-04
FIGURE 20-4 Correlation of GDP in EU countries.
(Figure continues on next slide)
Miles & Scott/Macroeconomics: Understanding the Wealth of Nations
Chapter 20, Figure 20-04 continued
FIGURE 20-4 (Continued)
Miles & Scott/Macroeconomics: Understanding the Wealth of Nations
Chapter 20, Figure 20-04 continued
FIGURE 20-4 (Continued)
Miles & Scott/Macroeconomics: Understanding the Wealth of Nations
Chapter 20, Figure 20-05
FIGURE 20-5 Correlation of output among U.S. regions.
One answer
– Europe is not an optimum currency area:
» Most EU countries export from 10% to 20% of
their output to other EU countries.
» EU-U.S. trade is only 2% of U.S. GNP.
» Labor is much more mobile within the U.S. than
within Europe.
» Federal transfers and changes in federal tax
payments provide a much bigger cushion for
region-specific shocks in the U.S. than do EU
revenues and expenditures.
Another answer
– Europe is an optimum currency area:
» Intra EU trade is the big part of
international trade.
» High correlations between GDP of EU
economies