Optimum Currency Areas

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Optimum Currency Areas
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Optimum Currency AreasI

• A theoretical construct, no country conforms to
  the ideal but the US with high labor and capital
  mobility comes much closer to the ideal than
  Europe.
• In a currency area (with one single currency),
  asymmetric economic shocks are dealt with through
  the internal redeployment of resources rather
  than currency realignments.

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Optimum Currency Areas II

• Example from the US the rise in the price of oil
  in the 70s affected Texas differently than the
  Midwest (Asymmetric effect of external shocks).
  Energy-poor Midwest output fell and unemployment
  rose. Energy-rich Texas high oil prices raised
  output and employment of the oil producers and
  increased energy production.
• In an open and flexible economy such as the US
• a) with high level of labor and capital mobility
  Unemployed Midwest workers migrated to Texas in
  search of employment while capital flowed to
  Texas to finance construction and investment.
  Overtime, a new equilibrium with converging
  unemployment and wage levels were established in
  Texas and Midwest (labor costs fell in Midwest
  and rose in Texas).
• b) with fiscal federalism in the US Existence of
  a unified federal budget acts as an automatic
  economic stabilizer that counters recessions in
  lagging regions and somewhat dampens economic
  activity in booming regions, thereby smoothing
  out economic imbalances in two different regions.
  For example If Midwest is in recession, amount
  of federal taxes paid in this region falls
  automatically while payments from DC to
  Midwesterners for unemployment insurance and
  welfare increase. If California is experiencing
  a boom at the same time, its tax payments to the
  federal treasury rise and receipts from DC in the
  form of unemployment insurance etc. falls.

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Optimum Currency Areas III

• In either case, the federal budget in the US
  dampens disparities between regions.
• The counter-cyclical effects of the federal
  budget offset somewhere between 20 and 40 percent
  of differences in economic performance in the US.
• Other federal systems like Germany Within
  Germany, states make direct transfers to each
  other and less adjustment is left to the
  automatic workings of income taxes and benefit
  programs.

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Optimum Currency Areas IV

• A unified fiscal system must exist alongside a
  single currency and a centrally operated monetary
  policy for EMU to work.
• Before the single currency, an asymmetric shock
  with a preference shift towards German products
  away from French products would be handled
  through currency realignments. Germany
  experiencing a demand boost would generate a
  trade surplus and an appreciation of DM. Whereas
  France experiencing a fall in demand would
  generate a trade deficit and a depreciation of
  FF. (ASSUMPTION No wage flexibility or labor
  mobility in France and Germany? Need for exchange
  rate parity changes to correct for the effects of
  asymmetric shocks).

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Optimum Currency Areas

• Case with wage flexibility and labor mobility
  within Germany and France. There may be no need
  for a currency realignment.
• If wage flexibility, fall in demand for French
  products leads to a decline in wages in France
  (how likely is this given the observed downward
  rigidity of wages), increasing supply of French
  products, reducing their prices and making French
  goods more competitive. Hence, French trade
  deficit may be reduced. Germany by contrast
  experiences an increase in wages, which shifts
  its supply to the left creating inflation and
  loss of competitiveness for German products,
  eventually reducing the size of its trade
  surplus. End result Less need for a currency
  realignment for FF and DM parity.

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Optimum Currency Areas

• If labor mobility exists between Germany and
  France, then unemployed workers in France can
  relocate to Germany. No need to pay unemployment
  benefits in France (budget deficit does not have
  to increase in France) and trade deficit need not
  increase.
• If none of these two factors work, then France
  suffers from unemployment and twin deficits (in
  government budget and trade account) while
  Germany suffers from inflation and experiences a
  trade surplus. Pressure on FF for a depreciation
  and on DM for an appreciation. Exchange rate
  alignments solve these problems remarkably well.
• But this is no longer an option under single
  currency.
• As long as such asymmetric shocks affect the
  economies of the Union, there exists a case for
  a) increasing labor mobility and b) creating a
  federal budget for automatic transfers from one
  region to another within Europe (fiscal
  federalism).
• This last case is politically unacceptable
  Germans may be expected to raise taxes to finance
  transfers to France suffering from unemployment,
  budget deficit and trade deficit. Can this work
  politically within the EU?

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Why is Europe not an optimum Currency Area?

• No significant federal budget for the EU as a
  whole EU budget amounts to a few percentage
  points of the combined EU GDP.
• Limited amount of labor mobility (though getting
  more flexible)
• BUT capital mobility is almost full.
• The case for fiscal federalism at the EU level?
• How likely is this? Political constraints? Issue
  of sovereignty?