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Is the Eurozone an optimal currency area?
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What is an OCA?
• A geographical region which adopts a single currency to maximise economic efficiency and creates the greatest
economic benefit
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Mundell (1961) - areas that suffer large asymmetrical shocks are not likely to be successful currency areas
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Consolidate purchasing power (especially for smaller Western European countries who were not large enough to be an
economic force)
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Reduce transaction costs
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Mundell (1961) stresses the benefits deriving from:
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Better performance of money as a medium of exchange and as a unit of account- a single currency eliminates
deadweight losses due to currency transactions and to the need to collect and process information related to exchange
rates
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- greater price comparability
​ Increasing trade between the involved countries, because trade is no longer hampered by rapid changes of exchange
rates
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A single currency eliminates the direct exchange rate risk of cross-border investment within
the currency union
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In principle, the free movement of goods, services, capital, and labour was signed in the Treaty of Rome (came into force
in 1958)
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A single currency is only feasible if there is high factor mobility (labor and capital)
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​In the absence of wage and price flexibility during an
asymmetric shock, high labor mobility can restore full employment through emigration
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Since it is convenitonally assumed that capital is mobile, the real hurdle comes
from the lack of labour mobility
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Both
problems could be solved by a shift of the production factors from A, in which they are idle, to B, in which they are in
short supply
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Once the factors of production have
moved, the currency area’s nominal exchange rate E delivers a the real exchange rate λ1 that is best for each country
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In the USA, as employment
falls, regional emigration rises, thus, participation rate remains relatively unchanged
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Contrarily, in the EU, most of the drop in employment is met by a fall in participation rate
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Labour mobility, or migration, is the key to dealing with asymmetric shocks in a common-currency area
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the cost of settling in another country
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job opportunities
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different welfare systems: pension rights, unemployment benefits, health and retirement benefits
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These differences may introduce significant costs for a monetary union – these differences may lead to divergent wage
and price developments, even if countries face the same disturbances
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Centralised vs non-Centralised wage bargaining:
Centralised: Labour unions take into account the inflationary effect of wage increases
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When a supply shock occurs, they realize that that losses in real wages cannot be compensated by nominal wage
increases
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De-Centralised: Here, individual unions that bargain for higher nominal wages know that the effect of these nominal
wage increases on aggregate price level is small, because these unions only represent a small fraction of the labour
force
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In such a non-cooperative set-up no individual union has an incentive to take the first step in reducing its nominal wage
claim
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Bruno and Sachs (1985) state: In a less centralised wage bargaining structure with several labour unions, each union has
an incentive to increase the wages for its members (non- cooperative game leading to a sub-optimal equilibrium)

Product Diversification - Kenen (1969)
Severe shocks usually affect countries which specialize in a narrow range of goods ​

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Countries whose production and exports are widely diversified and of similar structure form an OCA
Kenen: Countries whose production and exports are widely diversified and of similar structure form an optimum
currency area
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Horváth (2007) calculates an index of dissimilarity of exports for individual countries as compared to Germany
(aggregate Eurozone data does not exist) for the period 1999-2002:
• Denmark, Latvia, Netherlands have the highest scores and are hence more exposed to asymmetric shocks
• Austria, Czech Republic, Italy, Slovenia, UK have very low scores
• Horváth (2007) concludes that economic diversification is sufficient in the new Eastern European member states
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Insurance systems can help to alleviate the adverse effects of countries hit by negative shocks
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Insurance system should not prevent the adjustment mechanism (of flexible wages and labour mobility) from working
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¡ The Federal government can then distribute compensating transfers to individual states if they were subject to an
asymmetric shock
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¡ Eurozone does not have such a body therefore such relief cannot be provided via a central fiscal body and thus debt
crises can deepen
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Therefore it is important to have a
fiscal transfers system to prevent these shocks from spreading
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An asymmetric shock is when an economic supply or demand is different from one region to another, or when the
shocks do not move tandem
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This is because asymmetric shocks make it difficult for the CB of a monetary union to conduct monetary policy
that is beneficial to each member of the union
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• Lets also assume that consumer tastes have changed so that they prefer German products to French products
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• This effect is likely to increase unemployment and reduce output (recession) in France and reduce unemployment in
Germany and increase output (Boom)
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Countries that experience very different demand and supply shocks (because their industrial structures differ greatly) will
find it more costly to form a monetary union
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​Do asymmetric shocks
occur frequently enough to be a serious concern? ​Empirical studies that measure the size and nature of asymmetric
shocks face the problem that some of the shocks may not be exogenous
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Bayoumi and Eichengreen (1993) find the size of the supply shocks experienced by the “periphery” countries are
approximately 2x as large as the core countries
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Unfulfilled criteria “More significant
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(Petreski, 2007)

Trade Openness - McKinnon (1962)
McKinnon: Countries that are open to trade and trade heavily with each other form an optimum currency area
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The introduction of the euro enhanced trade integration, because it has led to lower transactions costs, price
transparency, greater competition, and lower exchange rate uncertainty (i
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exchange risk is eliminated)
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Most EU countries (especially the smaller states) are very open to trade, which suggests that EU member-countries
mostly satisfy this criterion of OCA
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Price of domestic and foreign goods equalize (world price), and any change in one country‘s nominal exchange rate
changes that country’s prices such that the world price level remains the same
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Homogeneous Preferences
Common Currency members must share a wide consensus on the way to deal with shocks
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High inflation
• Low Leverage/Debt vs
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ECB
• Eurozone members predominantly share different views with regards to fiscal policy
• Huge differences in debt levels
• German 10y bond yield (0
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Greek 10y bond yield (9
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The political will to integrate is regarded by some as among the most important condition for sharing a single currency
(Mintz (1970))
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It determines the willingness and commitment of a state to joint economic policies,
common fiscal policy and a strong institutional linkage
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(Also expressed in Haberler, 1970)
“political will for adopting a single currency is the crucial one in the whole story
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Financial Market Integration
Money Market/Banking Sector
• From 1999-2010 money markets fully integrated, which means same interest rate for all lending (interbank lending)The EURIBOR
• Sovereign debt crisis (2010-) ended this
• Local banks are main holders of government debt of the country they operate in
• Due to large losses, borrowing rates for banks increased faster than lending rates
• Many banks lost access to interbank market and were forced to obtain financing from ECB
Bond Market
• Seemed very much integrated since launch of Eurozone
• French vs
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American capital markets
redistribute 48% of asymmetric shocks whereas European capital markets only around 15%

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