Question

Using the GG-LL graph, explain why the EU does not qualify as an optimal currency area. Your answer should include the factors necessary for a region to be a good candidate for adoption of a single currency.

Answer 1

Solution:

First we will draw GG-LL Graph

The GG line in the graph tells us the benefit a country gains while joining the euro zone i.e pegging its currency against Euro. Its generally upward slope.The LL line in the graph tell us the potential loss (Economic stability) a country gains while joining euro zone. It slopes downward. Now at the point of intersection a country decide whether to peg its country against the Euro or not.

If there is a shift in the output market variability the demand for export of a country will shift. Thus it changes the LL line and degree at which a country's willingness to adopt the currency. Below graph can illustrate

Now we can see that if there is a change in LL line country willingness to adopt the currency as single currency will change. Now we look at the factors wheat prevent Eu to be an optimum currency.

As we know that optimum currency area is a area where there is a single currency that serves the economic purpose of all its memeber if the degree of output and factor among them is high.

Optimum currency depends upon two factors trade and factor mobility. But in case of Euro these factors are not in favor of EU. below are the regions-

- The labor force in the EU is more rigid than US. Mobility of US labor force is high compare to EU.

- The trade between EU countries are also very less around 10 to 20% ( Internet Source)

- US has better tax structure that provides more flexiblity than EU to absorb any economic unstable situation.

- There are only 12 countries that applied Euro as the common currency.