E.I. (Fach) / Optimum Currency Areas (Lektion)

S.16 -19

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• Benefits and Costs of an OCA Money exhibits increasing returns to scare (network externalities) ->e.g. save transaction costs Loss of monetary and exchange rate instruments Matters in presence of : price and wage stickiness and assymetric shocks
• Assymetric shock (S.16) If central bank depreciates common exchange rate to λ1: potentially inflationary excess demand If λ0 stays: A->C If λ adjusts freely: λ2: excess supply in countra A and escess demand in country B -> desequilibria do not stay foever: in country A price and wages will decline -> production moves to equilbrium (<-> country B)
• Criteria for an OCA Economic: labour mobility diversion tradeopenness Political: transfers homogeneous preferences common destiny
• a) Labour mobility (Mundell) Caveats: easy within national border but not across national orders capial mobility: difference between financial and physical capital in case of country spezifikation, skills matter and hinder labour mobility (Graph S.16)
• B) Production diversification (Kenen) Countries whose production and exports are widely diversified and of similar structur form an OCA -> in order to reduce the likelihood of asymmetric shocks
• Openness (McKinnon) Countries which are very open to trade ande heavily with each other form an OCA ->distinguish between traded an non traded goods: traded good's prices are set worldwide a small economy is price-taker, so the exchange rate does not affect competivivness if all goods are traded , domestic prices must be flexible and the exchange rate does not matter for competiviness
• d) Fiscal transfers Countries that agree to compensate each other for adverse shock form an OCA transfers can act as an insurance that mitigates the costs of an asymmetric shock transfers exist within national border: Implicitly through welfare system (e.g. unemployment benefits) Explicitly in federal states
• e) Homogeneous preferences Countries that share a wide consensus on the way to deal with shocks form an OCA matters primarily for symmetric shock prevalent when Kenon criterion is satisfied favor exporters (currency depreciation ) or consumer (currency appreciation) may also help for asymmetric shocks better understanding of partners' action encourages transfers
• f) Commonality of destiny COuntries that view themselves as sharing a common destiny better accept the cost of operating an OCA A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interest This calls for accepting such economic costs in the name of a higher purpose Solidarity vs. Nationalism
• Is Europe an OCA? - Labour mobility migration response to economic incentives must consider many costs (moving, risk of unemployment, family prospects, taxation, cultural differences...) in international comparison labour mobility is low in Europe and even within countries -> implies that unemployment bears much of the burden of adjustment to shocks
• Is Europe an OCA? - Production diversification Most EU-countries have a diversified production structure -> Kenen criterion is broadly satisfied
• Is Europe an OCA? - Fiscal transfers 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 these funds do not vary with business cycle and are not earmarked to adress asymmetric shocks This changes with ESM facilites in the course of Eurocrisis
• Is Europe an OCA? - Homogeneous preferences Preferences could affect role of monetary and fiscal policies to address external shcock little is known about this criteria Eurobarometer suggest that people agree on common decisionmaking for defence (64%) but reject common decisionmaking in the area of social affairs Eurocrisis shows increasing tension across nations (e.g. fiscal transfers and macroeconomic policies)
• Is Europe an OCA? Labour mobility: NO Production diversification: YES Openness: YES Fiscal transfers: NO (but increasing) Homogenous preferences: Partly Commonality of destiny: ?
• Will trade deepen? Little evidence that reducin exchange rate volatility increases trade Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot
• Will diversification grow or decline? intra-industry trade will grow specialization will increase (comparative advantage) -> no firm conclusion
• EMU and labour markets Mobility may not change much but wages could become less sticky Two viewes Virtuous circle: labour markets respond to enhanced competition by becoming more flexible hardening view: labour markets respond to enhanced competition by increasing protective measures that raise stickiness
• Are the other criteria endogenous? Transfers: no support for more tayes to finance transfers at beginning of EMU but now 50% of German population support transfers to bailout Greece Homogeneity of preferences: No presumption that will change soon but crisis may force countries to do so Commonality of destiny: No presumption that will change soon
• Summary : Is EU an OCA Monetary Union is not only about economics OCA does not send clear signal -> tells us only partly where cost will arise labour markets and unemployment political tension in presence of deep asymmetric shocks

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