Question

In: Economics

make analysis by yourself to judge if EU is an optimum currency area?

make analysis by yourself to judge if EU is an optimum currency area?

Solutions

Expert Solution

An optimal currency area (OCA) is the geopolitical area that has a single and unified currency which provides the best balance of economies of scale to a currency and effectiveness of macroeconomic policy to promote growth and stability. Based on the degree of integration and similarity between economies, Robert Mundell had outlined criteria for an OCA.

According to Mundell the criteria for an OCA are:

  • Greater mobility of labour among member countries. This is possible by the lifting or lowering of administrative barriers such as visa-free travel, cultural barriers , and institutional barriers.
  • Capital mobility as well as flexibiliy of price and wages based on the market forces of demand and supply.
  • A currency risk-sharing or fiscal mechanism to share risk across countries in the OCA which implies transfer of money from surplus countries to countries with economic difficulties.
  • Synchronous or highly correlated ups and downs in the business cycles of member countries due to similar monetary policy adopterd by the OCA Central bank.

Other criteria are:

  • The trade volume, between countries, will be high.
  • Diversified production within economies.
  • Homogeneous fiscal and monetary policy preferences across members.
  • Close structural similarities among the members.
  • Similar propensities to inflation and BOP disequilibrium.

The members of European Economic Community EEC, now European Union (EU), launched a single currency, ‘Euro’ with effect from 1st January, 1999.

EU is the most prominent example of OCA. However some members like Denmark and Sweden have not accepted Euro.

Tying their exchange rates together and agreeing to denominate all debts in euros, the Euro Zone, a subset of the EU made a prominent economic integration of a currency area that the world had seen. However, all members of the EU is not a part of Euro zone.

According to Mundell, an optimal currency area is a region where the benefits of sharing a common currency outweigh the costs.

The amount of resource mobility, capital as well as labour is fairly high in the EU, thus satisfying a condition of OCA.

There is an argument that the EU has not adequately provided for the greater economic and fiscal integration necessary for cross-border risk-sharing. A “no-bailout” clause that specifically restricted fiscal transfers has been included by the European Stability and Growth Pact . This got ditched early on in the sovereign debt crisis.


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