2012 01 31 a Theory of Optimum Currency Areas

IntroductionOptimum Currency Areas in Theory

Optimum Currency Areas in Practice: The EMU

A Theory of Optimum Currency Areasby Robert A. Mundell (1961)

Christoph Belak

Seminar onClassical Papers in Mathematical Economics and Finance

Stochastic Control and Financial Mathematics GroupUniversity of Kaiserslautern

January 31, 2012

Christoph Belak A Theory of Optimum Currency Areas 1 / 17



Overview

1 Introduction

2 Optimum Currency Areas in Theory

3 Optimum Currency Areas in Practice: The EMU




Robert A. Mundell

Some facts about Robert A. Mundell:

Born October 24, 1932, in Kingston, Canada

PhD in Economics, 1956 (MIT)

Professor at Columbia University and ChineseUniversity of Hong Kong

In 1999, Mundell won the Nobel Prize in Economics

“... for his analysis of monetary and fiscal policy under differentexchange rate regimes and his analysis of optimum currencyareas.”

www.nobelprize.org




What is an Optimum Currency Area?

Optimum Currency Area (OCA)

An optimum currency area is a geographical region, in which it wouldmaximize economic efficiency to have the entire region share a singlecurrency. It describes the optimal characteristics for the merger ofcurrencies or the creation of a new currency.

Examples of (optimal?) currency areas:

the Eurozone

the United States

...

In 1961, Robert Mundell published his paper “A Theory of OptimumCurrency Areas” which pioneered this theory.




Optimum Currency Areas in Theory

1 Introduction






Currency Areas and Common Currencies

In a currency area comprising different countries with national currenciesand fixed exchange rates the pace of employment in deficit countries isset by the willingness of surplus countries to inflate.

In a currency area comprising many regions and a single currency, thepace of inflation is set by the willingness of central authorities to allowunemployment in deficit regions.

The Optimum Currency Area is not the World

A currency area of either type cannot prevent both unemploymentand inflation among its members. The fault lies not with the type ofcurrency area, but with the domain of the currency area.




















National Currencies and Flexible Exchange Rates

The remedy in the previous examples is to allow flexible exchange ratesto correct the imbalance between the two countries and also relieveunemployment and inflation.

However, this effect may not work in every example.

Consequences of the Example

The flexible exchange rate system is not necessarily preferable to acommon currency or national currencies connected by fixed exchangerates.




















Regional Currency Areas and Flexible Exchange Rates

The previous considerations imply, that the optimum currency area isthe region, which Mundell defines as an area within which is factormobility, but between which there is factor immobility.

Factors of Production

The classical factors of production are

1 LandSite of production, natural resources (water, air, soil, minerals, ...).

2 LaborHuman effort used in production.

3 CapitalHuman-made goods, which are used in the production of othergoods (machinery, tools, buildings, ...).




Regional Currency Areas and Flexible Exchange Rates

The previous considerations imply, that the optimum currency area isthe region, which Mundell defines as an area within which is factormobility, but between which there is factor immobility.

Factors of Production

The classical factors of production are

1 LandSite of production, natural resources (water, air, soil, minerals, ...).

2 LaborHuman effort used in production.

3 CapitalHuman-made goods, which are used in the production of othergoods (machinery, tools, buildings, ...).




Upper Limits on the Number of Currency Areas

In order to ensure internal stability, currency areas should be chosen assmall as possible. However, there are several reasons, why currencyareas should not be chosen too small.

1 Maintenance costs increase with the number of currency areas.

2 Money is a convenience.

3 Single speculators should not be able to affect market prices onforeign exchange markets.

4 Flexible exchange rates lose effectiveness if the number ofcurrency areas increases.

Furthermore, currency is an expression of national sovereignty.






















































Criteria for a Successful Currency Union

Question: How can we decided now if a currency union is optimal?


1 Labor mobility (i.e. physical ability to travel, lack of culturalbarriers, ...)

2 Capital mobility and price and wage flexibility

3 A risk sharing system (e.g. an automatic fiscal transfer mechanismto redistribute money)

4 Similar business cycles of all participating countries

Additional criteria suggested are: Production diversification,homogeneous preferences, ...




























































1 Introduction






The Maastricht Treaty

Before introducing the Euro, the European Union had to ensure that theEurozone is an optimum currency area. In 1993, the MaastrichtTreaty set out strict guidelines for member states to follow with theultimate goal of adopting a single currency.

The aim of the treaty is to establish convergence criteria, which EUmember states have to satisfy to join the European Monetary Union.The convergence criteria can be seen as the European Commission’sinterpretation of the theory of optimum currency areas.




Convergence Criteria


1 Inflation rates: No more than 1.5% higher than the average of thethree best performing member states of the EU.

2 Government finance

1 Annual government deficit: the government budget deficit mustnot exceed 3% of GDP.

2 Government debt: the government debt must not exceed 60% ofGDP.

3 Exchange rate: Applicant countries should have joined theexchange-rate mechanism (ERM II) under the European MonetarySystem (EMS) for two consecutive years and should not havedevalued its currency during the period.

4 Long-term interest rates: The nominal long-term interest ratemust not be more than 2% higher than in the three lowest inflationmember states.







2 Government finance1 Annual government deficit: the government budget deficit must

not exceed 3% of GDP.

2 Government debt: the government debt must not exceed 60% ofGDP.










not exceed 3% of GDP.2 Government debt: the government debt must not exceed 60% of

GDP.











GDP.











GDP.






Empirical Comparison: EMU vs. US (1991-1997)

EMU US

Labor Mobility

Comparatively lower Plays high role inadjustment process(substituting priceflexibility)

Capital Mobility

Low High

Fiscal Tools

Insignificant Absorbs about 40% ofthe shocks

Price Flexibility

Crucial for adjustment Insignificant

The studies suggest, that a single European currency could increase theadjustment costs in EMU countries.





EMU US

Labor Mobility Comparatively lower Plays high role inadjustment process(substituting priceflexibility)

Capital Mobility

Low High

Fiscal Tools


Price Flexibility







EMU US


Capital Mobility Low HighFiscal Tools


Price Flexibility







EMU US


Capital Mobility Low HighFiscal Tools Insignificant Absorbs about 40% of

the shocksPrice Flexibility







EMU US



the shocksPrice Flexibility Crucial for adjustment Insignificant






EMU US



the shocksPrice Flexibility Crucial for adjustment Insignificant





Endogenous Optimum Currency Area

The empirical evidence suggests, that when the EMU was created, theEurozone was not an optimum currency area.

However, the economic union has enhanced labor and capital mobilitywithin the EU. Hence, to some degree, the Eurozone automaticallydevelops into an optimum currency area, simply by adopting a commoncurrency. This is called an

Endogenous Optimum Currency Area.




Any Questions??




Thank you for your attention!!!


2012 01 31 a Theory of Optimum Currency Areas

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