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Optimum currency area theory adopts the presumption that a currency area confers a benefit upon its members by eliminating [[exchange rate risk]]s and reducing transactions costs. Its analysis concerns the extent to which that benefit may be offset by the risk of an additional cost when there is a [[recession]]. Such an additional cost arises when there is a difference between the [[monetary policy]] response to the recession that is appropriate for a member country, and that which is appropriate for the currency area as a whole. When that happens, some member countries may suffer unemployment and other economic costs that they could have avoided if they had retained control over their national monetary policies. It is liable to happen when the currency area experiences an [[asymmetric shock]] which affects the economies of some member countries more than others. | Optimum currency area theory adopts the presumption that a currency area confers a benefit upon its members by eliminating [[exchange rate risk]]s and reducing transactions costs. Its analysis concerns the extent to which that benefit may be offset by the risk of an additional cost when there is a [[recession]]. Such an additional cost arises when there is a difference between the [[monetary policy]] response to the recession that is appropriate for a member country, and that which is appropriate for the currency area as a whole. When that happens, some member countries may suffer unemployment and other economic costs that they could have avoided if they had retained control over their national monetary policies. It is liable to happen when the currency area experiences an [[asymmetric shock]] which affects the economies of some member countries more than others. | ||
The term "optimum currency area" is believed to have been coined by the eminent economist Robert Mundell to denote the theoretical concept of an area in which there are no such offsetting costs. Mundel's analysis demonstrated that a sufficient condition for its definition would be would be either a frictionless migration of labour, or a frictionless adaptation of labour and product costs, in response to a change in demand<ref>Robert Mundell: ''A theory of Optimum Currency Areas'', American Economic Review, 51 (4), 1961</ref>. Developing Mundell's analysis, Robert McKinnon has argued that the more open the economies of a currency area, the lower will be the costs arising from price rigidities<ref>Ronald McKinnon: ''Optimum Currency Areas'', American Economic Review, September 1963</ref>, and Peter Kenen has argued that the greater the similarity of the economies of a currency area the smaller will be the magnitude asymmetric shocks, and that the more diversified is an individual economy the lower will be its vulnerability to such shocks <ref>Peter Kenen: "The Theory of Optimum Currency Areas: An Eclectic View" in R.Mundell and A. Swoboda eds, ''Monetary Problems of the International Economy'', The University of Chicago Press, 1969</ref>. | The term "optimum currency area" (OCA) is believed to have been coined by the eminent economist Robert Mundell to denote the theoretical concept of an area in which there are no such offsetting costs. Mundel's analysis demonstrated that a sufficient condition for its definition would be would be either a frictionless migration of labour, or a frictionless adaptation of labour and product costs, in response to a change in demand<ref>Robert Mundell: ''A theory of Optimum Currency Areas'', American Economic Review, 51 (4), 1961</ref>. Developing Mundell's analysis, Robert McKinnon has argued that the more open the economies of a currency area, the lower will be the costs arising from price rigidities<ref>Ronald McKinnon: ''Optimum Currency Areas'', American Economic Review, September 1963</ref>, and Peter Kenen has argued that the greater the similarity of the economies of a currency area the smaller will be the magnitude asymmetric shocks, and that the more diversified is an individual economy the lower will be its vulnerability to such shocks <ref>Peter Kenen: "The Theory of Optimum Currency Areas: An Eclectic View" in R.Mundell and A. Swoboda eds, ''Monetary Problems of the International Economy'', The University of Chicago Press, 1969</ref>. Later studies have examined the effects upon the OCA criteria of changes to member states' economies that might take place, and some authors believe that the criteria could be satisfied as a result of convergence after joining even if it they are not fully satisfied before<ref>[http://www.ecb.int/pub/pdf/scpwps/ecbwp138.pdf F Paolo: ''"New" Views on the Optimum Currency Area Theory: What is EMU Telling Us?'', European Central Bank, 2002]</ref>. On the other hand, it has been suggested that there may be increased national specialisation as a result of improved trading opportunities, and that this could lead to divergence rather than convergence. | ||
==OCA theory and the Eurozone== | ==OCA theory and the Eurozone== | ||
Revision as of 05:39, 21 February 2011
Optimum currency area theory
Optimum currency area theory adopts the presumption that a currency area confers a benefit upon its members by eliminating exchange rate risks and reducing transactions costs. Its analysis concerns the extent to which that benefit may be offset by the risk of an additional cost when there is a recession. Such an additional cost arises when there is a difference between the monetary policy response to the recession that is appropriate for a member country, and that which is appropriate for the currency area as a whole. When that happens, some member countries may suffer unemployment and other economic costs that they could have avoided if they had retained control over their national monetary policies. It is liable to happen when the currency area experiences an asymmetric shock which affects the economies of some member countries more than others.
The term "optimum currency area" (OCA) is believed to have been coined by the eminent economist Robert Mundell to denote the theoretical concept of an area in which there are no such offsetting costs. Mundel's analysis demonstrated that a sufficient condition for its definition would be would be either a frictionless migration of labour, or a frictionless adaptation of labour and product costs, in response to a change in demand[1]. Developing Mundell's analysis, Robert McKinnon has argued that the more open the economies of a currency area, the lower will be the costs arising from price rigidities[2], and Peter Kenen has argued that the greater the similarity of the economies of a currency area the smaller will be the magnitude asymmetric shocks, and that the more diversified is an individual economy the lower will be its vulnerability to such shocks [3]. Later studies have examined the effects upon the OCA criteria of changes to member states' economies that might take place, and some authors believe that the criteria could be satisfied as a result of convergence after joining even if it they are not fully satisfied before[4]. On the other hand, it has been suggested that there may be increased national specialisation as a result of improved trading opportunities, and that this could lead to divergence rather than convergence.
OCA theory and the Eurozone
The eurozone does not meet Mundell's labour migration or cost flexibility requirements. Labour mobility is low[5] and there is limited wage and price flexibility[6][7]. There have also been large differences in economic and financial structures[8]. and the initial expectation that mewmbership would reduce them has not been realised[9].
References
- ↑ Robert Mundell: A theory of Optimum Currency Areas, American Economic Review, 51 (4), 1961
- ↑ Ronald McKinnon: Optimum Currency Areas, American Economic Review, September 1963
- ↑ Peter Kenen: "The Theory of Optimum Currency Areas: An Eclectic View" in R.Mundell and A. Swoboda eds, Monetary Problems of the International Economy, The University of Chicago Press, 1969
- ↑ F Paolo: "New" Views on the Optimum Currency Area Theory: What is EMU Telling Us?, European Central Bank, 2002
- ↑ Alexandre Janiak and Etienne Wasmer: Mobility in Europe, European Commission, 2008
- ↑ Alfonso Arpaia and Karl Pichelmann: Nominal and real wage flexibility in EMU, European Commission, 2007
- ↑ Emmanuel Dhyne, Jerzy Konieczny, Fabio Rumler and Patrick Sevestre: Price Rigidity in the Euro Area, European Commission, 2009
- ↑ Massimo Suardi: EMU and asymmetries in monetary policy transmission, European Commission, 2001
- ↑ Clas Wihlborg, Thomas Willett and Nan Zhang: The Crisis in the Eurozone, World Economics, October-December 2010
- ↑ Paul de Grauwe: The Political Economy of Monetary Union in Europe, The World Economy, November 1993