Optimum Currency Area Theory and Its Evidence

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Table of Contents

Theory Explanation
Internal Evidence
External Criteria
International Practice
Conclusion
Lessons Learned and Recommendations
References

International trade and economics is a complex mechanism which is meant to function at a carefully established balance. Widespread practices are based upon theoretical concepts that have been developed and adapted to macroeconomic realities over time. The purpose of this research paper is to investigate the theory of optimum currency area which is a controversial but potentially critical concept to the future of global economics. In this report, the theory will be explored in-depth, including its origins and economic fundamentals as well as practical applications in current international affairs. The theory of optimum currency area is difficult to maintain at a large scale based on the original theoretical framework since it leads to the creation of severe destabilizing effects on the economic region but may be improved upon to ensure the continuity of the monetary union.

Theory Explanation

The Optimum Currency Area Theory was developed by Robert Mundell in 1961. It was later improved by Peter Kenen and Ronald McKinnon. The theory seeks to present the argument which outlines circumstances that provide benefits to integrate into an economic union using a mutual currency. The underlying decision of participating in a currency union requires balancing the loss of economic stability with monetary efficiency benefitssince national policy essentially becomes obsolete.

Mundell’s original publication using the term ‘optimum currency area’ was based on previous research regarding flexible exchange rates. He argued that macroeconomic realities and laws of international trade establish the need for flexible exchange rates and common currency areas. At the time, it was incomprehensible that any country would be willing to abandon its national currency. The optimal currency area was described as a region with a unified currency which would provide economic welfare and increase the performance of member states. Meanwhile, a high level of integration allows for the utilization of factor mobility as a mechanism to manage economic shocks. Mundell strongly emphasized factor mobility as the basis to his theory. Price and wage flexibility would allow for the distribution of resources, both financial and labor, dependent on their need in an economic area based on supply and demand variations. It would help balance out and resolve economic issues across national borders (Mundell, 1961). For example, free movement of labor allows to balance out unemployment in a member state with inflation in another. In a common currency area, the adjustment occurs due to theflexibility of both wages and labor.

Internal Evidence

Mundell develops a vision that the world would be divided into currency areas based on geographical regions, each with a separate currency. There would be factor mobility and a fixed exchange rate within the areas while factor immobility and a flexible rate would be prevalent between them. For a flexible exchange rate to be practical in a global economy, Mundell identifies several factors which must be fulfilled. An international price system must remain stable after accounting for speculation. Variations in exchange rates must not be significant to distort export and import-competing industries. Economic risks based on exchange rates are insured as well as the protection of debtors and creditors to ensure capital movements. The central bank must avoid monopolizing speculation. Finally, wages and profits must not be connected to a price index dependent on import goods (Mundell, 1961).

An optimum currency area presents specific attributes that are beneficial to national economies, thus making it appealing to create an economic union with an internal fixed exchange rate while having a flexible rate with the outside world. It is recommended that a country must maintain a diverse variety of industries in order to mediate sector-specific shocks. The larger the economy, the more benefit it would gain from a flexible exchange rate. An open economy with a strong partner trade relationship would significantly benefit from a common currency area. Countries with similar labor market structures and business cycle synchronization will have more compatibility in a currency union and would not have to rely on flexible exchange rates for theadjustment. Members of an optimum currency area benefit from lower transaction and accounting costs while ensuring stability and predictability to relative prices that help with international business practice. On a financial level, a monetary union provides insulation from currency volatility and speculative bubbles that commonly result in unstable real exchange rates. However, participation in a currency area indicates the ability to use national monetary policy, inflation tactics, and speculation to respond to any domestic or regional macroeconomic challenges (Broz, 2005).

External Criteria

The optimum currency area theory provides a set of external criteria which assess a country’s ability to enter a monetary union, examining its ability to withstand economic pressures and adequately facilitate adjustments on the level of international cooperation. Firstly, countries in a union must maintain similar economic structures which would significantly reduce the impact of asymmetric shocks. This occurs since similar structures allow for fiscal policy to have a sweeping and comparable effect amongst all member states. Furthermore, countries with active international trade must not face severe loss of economic sovereignty by giving up their exchange rate as membership results in integration of product and trade markets (Jager & Hafner, 2013).

All member states should have homogeneity of socio-economic ideals as a critical measure of the ability of the union to manage any arising crisis. Consensus on monetary policy allows to oversee asymmetric shocks since the currency union would have to adopt a universal approach for all countries. The currency area must maintain factor mobility which is the free movement of labor and capital that serve as a stabilizer. Finally, the existence of a transfer system is necessary which would allow moving investments and money to accommodate economic shocks, country-specific recessions, and balance-of-payments issues (Jager & Hafner, 2013).

A monetary union of countries that is anchored to a common stable currency allows to manage inflation more efficiently. However, it creates limits to using fiscal policy to respond to internal asymmetric and financial shocks or any external variations in exchange rates. Net benefitsmay change for a country based on economic realities. Membership in a monetary union may lead to theinhibited growth of anational industry which may be dependent on external funding or limit diversification of exportable trade. Tightly integrated unions provide financial stability insurance through pooling techniques and bail-out measures. Meanwhile, poor financial integration or depth within a union would result in difficulties when faced with dynamic economic challenges. An optimum currency area implies the existence of policies and financial institutions which would serve as a guarantor and stabilizer for any fiscal operations or moral hazards. However, it would require significant cooperation amongst member states to prevent any ‘tragedy of the commons’ scenarios (Aizenman, 2016).

International Practice

The interconnection of politics and economics results in challenges for countries in an optimum currency area since economic sovereignty becomes significantly dependent on an external governing body. However, participation brings a variety of advantages in international trade and capital flow as well as the cohesion of a strictly regulated currency market. The optimum currency area theory is most applicable to the European Union which has shown signs of economic prosperity while simultaneously encountering critical challenges in its operation. As more countries wish to join or leave the union, Mundell’s theoretical framework becomes critical in examining the criteria to determine if the European Union is an optimum currency area.

It can be assumed that the European Union fits within the criteria for an optimum currency area given some leniency. However, it is unclear which model of development would be going forward. It has been found that within regions of countries, labor mobility is active in the adjustment process more than the exchange rate, with the opposite effect being evident at the national level. This presents a case for exploration of the effect of labor mobility to compensate for exchange rate flexibility. Furthermore, asymmetric shocks occur more at the regional level than for whole countries. A lower occurrence of national asymmetric shocks serves as a positive indication that further economic integration is possible within the European monetary union without fear of adjustment costs since theoretically, the asymmetric shocks would be much rarer. However, closer integration would result in regional agglomeration and the divergence of economic developments which may lead to asymmetric shocks having a concentrated effect on a specific region based on the industry located there (De Grauwe&Vanhaverbeke, 2014).

Currently, Europe is following a dual model of development. Northern industrial nations such as Germany follow a balanced approach of increased regional labor mobility, with stable output and employment. Meanwhile, the southern model has immobile labor mobility with significant divergences of output and regional bubbles of unemployment (De Grauwe&Vanhaverbeke, 2014). In order to remain as wholesome optimum currency area, the European Union will have to converge on a specific model of development. While the northern model is more appealing, either one will be costly to individual countries in the monetary union.Labor mobility remains a deciding force for the European Union, similar to the theoretical predictions of Mundell’s framework.

The theory of optimal currency area emphasizes that the lack of labor mobility would have to be compensated by national fiscal policy. However, the existence of regulation on the fiscal policy would render countries unable to manage asymmetric shocks. The European Union was designed as a suboptimal monetary alliance,but until the global financial crisis of 2008, this concept was widely disregarded as a purely theoretical framework.An asymmetric shock is incompatible with the constraint of national fiscal policies and the financial market will begin to expect critical adjustment issues. The crisis showed that a suboptimal monetary union had significant repercussions to financial stability and market integration within Europe. Based on the theory, the market is pushed into a crisis and destabilizes the equilibrium in the union. It is exemplified by a recession with significant capital outflows and spread of government bonds which negatively impacts public finances (De Grauwe&Foresti, 2016).

There is an inherent existence of a trade-off phenomenon between fiscal policy regulation, financial stability, and economic integration within the European Union. If there is trust in the union, any asymmetric shocks are dealt with by capital flow of financial markets, requiring little regulation as occurred in the decade leading up to 2008. However, once markets lost confidence in the practicality of the optimum currency area, fiscal policy must come into place to maintain the financial sustainability and integration. If regulation prevents national governments from freely using fiscal policy, financial stability would be compromised as evident in the post-crisis years (De Grauwe&Foresti, 2016).

Conclusion

The theory of optimum currency area was developed as a theoretical framework for a potential regional monetary union. It seeks to address the benefits and challenges that individual countries and the union as awhole wouldbe exposedto. The theory develops a method for establishing an optimum exchange rate regime. Further iterations and approaches to the optimum currency area have been introduced to create criteria and outline favorable conditions for countries to form a monetary union. Eventually, these frameworks were applied into practice with the establishment of an economic experiment known as the European Union. Over the years and experience of financial pressures, it was determined that the design of an optimum currency area presents certain flaws but can be maintained with gradual macroeconomic improvement to its function.

Lessons Learned and Recommendations

The practical application of the optimum currency area as the European Union, unfortunately, showed that the theory was developed with particular flaws, thus resulting in gaps in macroeconomic policies and function of the monetary union. The role of banking institutions and their flow of capital were disregarded when it came to accounting for asymmetric shocks. A banking union was not envisioned as a component of the monetary union which would manage account imbalances and loans. The European Central Bank should have been designed to not only supervise monetary policy but also serve a guarantor of the overall economic system and the currency’s liquidity. Labor mobility and wage flexibility were designed to be a reliable method of adjustment but fundamentally failed due to socio-economic divides and preconditions. Nations entering the European Union were unready to give up national economic sovereignty and fiscal stabilization for the sake of the optimum currency (Eichengreen, 2014).

Once a monetary union is formed, it would be devastating to regional and global economies to break it up. However, as evident with the European Union, it is possible to implement macroeconomic and structural modifications to the monetary alliance. This improves its function and builds upon the optimum currency area theory by eliminating design flaws. For example, to prevent recession of member states, mechanisms of automatic fiscal stabilization can be implemented. However, it would also require developing a process that would restructure crippling debt. The European Union has begun to formulate procedures to manage capital flow and account imbalances but requires a framework for their enforcement. The Fiscal Compact provides an option to introduce rules into national constitutions that would focus on cyclically adjusted budget deficits. Furthermore, it may be beneficial to create an independent forecasting commission for growth that would not be dependent on government manipulation of statistics, thus creating accountability and a competent analytical framework (Eichengreen, 2014). Overall, the optimum currency area theory has proven to be challenging to implement in its original form. However, with significant modifications to the design of a monetary union, it becomes a practical economic endeavor which reaps significant benefits for regional interaction.

References

Aizenman, J. (2016). Optimal currency area: A 20th century idea for the 21st century? Web.

Broz, T. (2005). The theory of optimum currency areas: A literature review.PrivrednaKretanjaiEkonomska, 15(104), 53-78. Web.

De Grauwe, P.,&Vanhaverbeke, W. (2014). Chapter 8: Is Europe an optimum currency area? Evidence from regional data. In P. De Grauwe (Ed.), Exchange rates and global financial policies (pp. 231-252). Singapore, Singapore: World Scientific.

De Grauwe, P.,&Forestil, P. (2016). The quality of online social relationships. Economics Letters, 145, 278-281. Web.

Eichengreen, B. (2014). The Eurozone crisis: The theory of optimum currency areas bites back. Web.

Jager, J., & Hafner, K. (2013). The optimum currency area theory and the EMU. Intereconomics, 48(5), 315-322. Web.

Mundell, R. (1961). A theory of optimum currency areas. The American Economic Review, 51(4), 657-665. Web.

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