Optimum currency area. Is a fixed exchange rate regime more suitable than a flexible one?

Table of Contents

1. Introduction

2. History and Development of the Theory of Optimum Currency Area
2.1 The “pioneering Phase”: from the early 1960s to the early 1970s
2.1.1 Price and wage flexibility
2.1.2 Mobility of factors of production including labor
2.1.3 Financial market integration
2.1.4 The degree of economic openness
2.1.5 The diversification in production and consumption
2.1.6 Similarities of inflation rates
2.1.7 Fiscal integration
2.1.8 Political integration
2.2 The “Reconciliation Phase” – the 1970s

3. The “Reassessment Phase:” – the 1980s and Early 1990s
3.1. The first try to establish a European currency
3.1.1 The end of World War II
3.1.2 Creation of the European Monetary System (EMS)
3.1.3 Preparation for the European Economic and Monetary Union (EMU)
3.2 The “Empirical Phase:” – from the 1980s to today

4 Fixed exchange rate and flexible exchange rate in an OCA
4.1 To Fix or to Float: the influence of Friedman in the 1950s
4.2 Mundell’s models
4.2.1 OCA with stationary expectations
4.2.2 OCA with international risk sharing
4.3 Extensions of the OCA theory

5 Fixed versus flexible exchange rates
5.1 The case for flexible exchange rates
5.1.1 Monetary Policy Autonomy
5.1.2 Trade Balance Adjustments
5.2 The case for fixed exchange rates
5.2.1 Monetary Discipline
5.2.2 Speculation
5.2.3 Uncertainty
5.2.4 Trade Balance Adjustments

6 Conclusion

7 Literature

8 Internet Sources

9 Appendix

1. Introduction

This term paper outlines the theory of Optimum Currency Area (OCA), also known as an Optimal Currency Region (OCR)¹. It also deals with the question under which conditions it is more suitable to have a fixed exchange rate regime or a flexible exchange rates regime in an OCA.

The theory of OCA was developed in the early 1960s and deals with mixed, complicated issues of international macroeconomics² and “emerged from the debate on the advantages and disadvantages of fixed versus flexible exchange rate regimes”³. Moreover the theory “attempts to answer the question under which circumstances it is beneficiary for a country or region to constitute a common currency area with other countries or region”.⁴ This question was analyzed and contributed by the pioneered work of Mundell (1961). Other contributors at the beginning of this theory were McKinnon (1962) and Kenen (1969).⁵ Their cognition were based on founding’s by Friedman (1953) and Meade (1957).⁶

At the beginning of the term paper the main phases of the OCA and the European Union will be explained. Therefore the history and development of the OCA theory will be outlined. The OCA theory can be divided into four phases. The first phase was the so called “pioneering phase”. It started at the early 1960s to the early 1970s. After that the phases “reconciliation phase”(the 1970s), the “reassessment phase” (the 1980s and early 1990s) and the “empirical phase” (from the 1980s to today) followed.⁷

After this, the two main types of the exchange rate will be explained and the question under which conditions it is better to have in an OCA a flexible or a fixed exchange rate regime will be answered by measuring the advantages and disadvantages of each exchange rate regime. At the end a conclusion will follow.

2. History and Development of the Theory of Optimum Currency Area

2.1 The “pioneering Phase”: from the early 1960s to the early 1970s

The first phase of OCA theory is the “pioneering phase” This phase started in the early 1960s and lasted to the early 1970s. The early 1960s were characterized by the Bretton Woods System.

The Bretton Woods System was signed in 1944 during World War II, when representatives from 44 countries met at Bretton Woods, New Hampshire, to create a new international monetary system of fixed exchange rates between major currencies.⁸ The statesmen set up a system of rules, institutions, procedures⁹ and established two multinational institutions.

The first of these multinational institutions is the International Monetary Fund (IMF) and the second institution is the World Bank.¹⁰ The main task of the IMF was “to maintain order in the international monetary system”¹¹ and the main task of the World Bank was “to promote general economic development”.¹² The only currency which remained convertible into gold was the dollar. All other countries had to fix the value of the currency in terms of gold. Member countries had to held their international reserves largely either in the form of gold or in the form of official price.¹³ In this way the dollar became a principle reserve currency. Despite of being very successful first, the Bretton Woods System collapsed in 1971. Statesman first tried to create a new fixed exchange rate system, but by 1973 most economically advanced countries decided to move to a flexible exchange rate system.¹⁴

The general problem of this phase was the properties ranking according to their importance. The OCA theory distinguishes eight properties, which an OCA should fulfill.¹⁵ In the following these properties, which are also called prerequisites, characteristics or criteria by some authors, are listed.

2.1.1 Price and wage flexibility

When different countries join a single currency area, and the nominal price and wages are flexible between these countries, the transition towards adjustment is less likely to be linked with continuing unemployment in one country and/or inflation in another country.¹⁶

2.1.2 Mobility of factors of production including labor

The mobility of factors of production has an effect on efficiency and welfare. This kind of mobility can be very rare at the beginning of creating a single currency area, but can display its effects over a certain period of time. The same pattern can be seen in the case of labor mobility, as there are significant costs for migration and retraining in a new country and also, in some cases, language barriers.¹⁷

2.1.3 Financial market integration

“Integration of financial markets is a process of unifying markets and enabling convergence of risk adjusted returns on the assets of similar maturity across the markets.”¹⁸ Financial integration allows to maintain temporary disturbances through capital inflows. This inflows can be, for example, occur by “borrowing from surplus areas or de-cumulating net foreign assets (risk sharing) that can be reverted when the shock is over.”¹⁹ Nevertheless, financial market integration is not an alternative for permanent adjustment.²⁰

2.1.4 The degree of economic openness

Openness in a currency area can have different dimensions. The most commonly was once the degree of trade integration of countries which shared a single currency. Trade integration means “the ratio of exports plus imports over GDP.”²¹ When a country has a high degree of openness, it will experience more changes in international prices, which will be reflected to the costs of living. In theory, small countries are more open than large countries.²²

2.1.5 The diversification in production and consumption

The criteria of diversification in production and consumption was introduced by Kenen. According to Kenen “a high diversification in production and consumption, i.e., in the “portfolio of jobs”, and correspondingly in imports and exports, dilutes the possible impact of shocks specific to any particular sector.”²³ For this reason diversification reduces the need for changes in the terms of trade via the nominal exchange rate. Moreover, disturbances can be abandoned.²⁴

2.1.6 Similarities of inflation rates

Structural developments, labour market, economic policies, and social preferences can be examples for external imbalances. If there is an inflation difference between the countries, this is not necessarily problematic.²⁵

2.1.7 Fiscal integration

According to Kenen (1969), countries sharing a supranational fiscal transfer system to redistribute funds to member country affected by an adverse asymmetric shock would also be facilitated in the adjustment to such shocks and might require less nominal exchange rate adjustments.²⁶

2.1.8 Political integration

Political integration is the most important condition for sharing a single currency. Therefore, political have to create joint commitments and institutional linkages. According to Haberler is a similarity of policy attitudes among partner countries the most essential step to a group of countries into a currency area.²⁷

2.2 The “Reconciliation Phase” – the 1970s

The second phase is called the “Reconciliation Phase”, also known as the second era of contribution, as the importance of OCA properties have been discussed and interpreted in more details. An important finding of this era was the role of similarity shocks of some properties.²⁸

At this time, different OCA properties had been brought together. The ranking also changed. It was still assumed that price and wage flexibility were at the highest rank. Openness and similarity in shocks were also important.²⁹ “But it was also argued that if members of a currency area are financially integrated, a high similarity of shocks among them, although desirable, is no longer a strict prerequisite.”³⁰

The size of a currency area also matters. The highly desirable property of mobility of factors of production and labor is important but is also connected with some costs. To sum up, the importance’s of the different properties depends on the view of the author.³¹ One author assumes that price and wage flexibility has the highest link, the other author ranks e.g. financial integration as the highest property.

3. The “Reassessment Phase:” – the 1980s and Early 1990s

The reassessment phase is also known as the “Old” versus the “New” OCA theory.³² However, this phase is based on the “old” OCA theory. Main points of this phase were the reconsideration of the costs and benefits regarding monetary integration and the optimal size and timing of a currency area.³³ This phase made not only a contribution to the OCA, but also to the Economic and Monetary Union (EMU).

Next follows a brief summary how the EMU was established.

3.1. The first try to establish a European currency

Long before the euro became part in our daily life in nineteen Member Countries of the European Union (EU),³⁴ the preparations for this started already in 1929, when Gustav Stresemann asked for the formation of an European currency.³⁵ Short time later, the New York Stock Exchange experienced the “Black Friday” and the economical crisis began. This crisis postponed the introduction of a single currency.

3.1.1 The end of World War II

As already described, during the World War II, the Bretton Woods System was established as well as IMF and the World Bank.

In order to prevent other wars, the United Nations was set up in 1945. On the 9 May 1950, the French foreign minister Robert Schuman called for the institution of a Community of Pacific Interests. “Following that declaration and the Schuman Plan, six countries (Germany, Belgium, France, Italy, Luxembourg and the Netherlands) signed the Treaty establishing the European Community of Steel and Coal (ECSC) on 18 April 1951.”³⁶ After the ECSC the European Economic Community (EEC) and the European Atomic Energy Community (EAEC) were established in 1957.³⁷

3.1.2 Creation of the European Monetary System (EMS)

A new attempt to establish a single currency took place in March 1979. With the initiative of Germany and France the European Monetary System was (EMS) created. This system is “based on the concept of fixed, but adjustable exchange rates.”³⁸ France, the Federal Republic of Germany, Italy and the Benelux countries were the first countries which created a system of fixed exchange rates.³⁹ Reasons why member countries fix internal exchange rates can be for example the desire to make Europe’s economic interest more effectively in the world and because of the wish to achieve greater internal economic unity.⁴⁰ The currencies of all original Member States – France, Germany, Italy, Belgium, Denmark, Ireland, Luxembourg and the Netherlands – began participating in the exchange-rate mechanism.⁴¹

3.1.3 Preparation for the European Economic and Monetary Union (EMU)

In June 1988, Jacques Delors became chairman of a committee which was set up by the Hanover European Council to study the European economic and monetary union.⁴² Other participations in the committee were Alexandre Lamfalussy, the General Manager of the Bank for International Settlements (BIS), governors of the then European Community (EC) national central banks, Miguel Boyer, the then President of the Banco Exterior de España and Danish professor for economics Niels Thygesen.⁴³

The committee worked on the so called Delors Report, which suggested that the economic and monetary union should be established on three steps.⁴⁴

In the first step, the movement of capital between member states of the European Union were abolished from the 1 July 1990 on.

The second step included the establishment of European Monetary Institute (EMI) on the 1 January 1994, as well as the establishment of the European Central Bank (ECB).

The third step followed on 1 January 1999 with the “irrevocable fixing of the exchange rates of the currencies of the 11 Member States initially participating in Monetary Union and with the conduct of a single monetary policy under the responsibility of the ECB.”⁴⁵ At this date the EMU was launched and the dollar had a stronger opponent than the mark. The new opponent of the dollar was from now on the euro. At the same time, the intra-EU exchange rate mechanism (ERM II) and the Stability and Growth Pact came into force.⁴⁶

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¹ BookRags, Inc.; http://www.bookrags.com/custserv/about.html; accress on 2011-07-11

² cp. Horvath, Julius; Optimum Currency Area Theory: A selected review; p. 7

³ Oshikoya, Temitope W.; Monetary and Financial Integration in West Africa; p. 22

⁴ Milbredt, Max; http://qed.econ.queensu.ca/pub/faculty/smithgw/econ826/exercises/Optimum%20Currency%20Areas.pdf; accress on 2011-07-11

⁵ cp. van Marrewijk, Charles; International Economics. Theory, Application, And Policy; p.618

⁶ cp. Mongelli, Francesco Paolo; “New” vies on the Optimum Currency Area Theory: What is EMU telling us?; p. 7

⁷ Bjarnason, Magnus; The political Economy of Joining the European Union: Iceland’s Position at the Beginning of the 21st Century; p. 94

⁸ cp. Hill, Charles W. L.; International Business: Competing in the Global Marketplace; p. 345

⁹ cp. van Marrewijk, Charles; International Economics: Theory, Application, and Policy; p. 472

¹⁰ cp. Hill, Charles W. L.; International Business: Competing in the Global Marketplace; p. 345

¹¹ Ibid.

¹² Ibid.

¹³ cp. Krugman, Paul R.; Obstfeld, Maurice; International Economics: Theory & Policy; p. 515

¹⁴ Kurgman, Paul; Robin Wells, Kathryn Graddy; Economics: European Edition; p. 878

¹⁵ cp. Mongelli, Francesco Paolo; “New” views on the Optimum Currency Area Theory: What is EMU telling us?; p. 8f.

¹⁶ cp. Mongelli, Francesco Paolo; http://ec.europa.eu/economy_finance/publications/publication12081_en.pdf; access on 2011-07-16 at 6:50 pm

¹⁷ cp. Ibid.

¹⁸ Reserve Bank of India; http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77579.pdf; access on 2011-07-16 at 7:10 pm

¹⁹ Mongelli, Francesco Paolo; “New” views on the Optimum Currency Area Theory: What is EMU telling us?; p. 9 ff.

²⁰ cp. Ibid.

²¹ Ibid.

²² cp. Ibid.

²³ Ibid.

²⁴ cp. Ibid.

²⁵ cp. Ibid.

²⁶ Ibid.

²⁷ cp. Ibid.

²⁸ Zace, Migena; Laci, Eglantina; http://ces.epoka.edu.al/icbs/17.pdf; access on 2011-07-17 at 11:30 am.

²⁹ cp. Ibid.

³⁰ Ibid.

³¹ cp. Ibid.

³² cp. Mongelli, Francesco Paolo; “New” views on the Optimum Currency Area Theory: What is EMU telling us?; p. 14 f.

³³ cp. Ibid.

³⁴ See Appendix 1

³⁵ cp. Euro Trading Trend; http://eurotradingtrend.com/euro-currency-formation-history.php; access on 2011-07-19 at 6:10 pm.

³⁶ Communication Department of the European Commission; http://europa.eu/legislation_summaries/economic_and_monetary_affairs/introducing_euro_practical_aspects/l25007_en.htm#KEY; access on 2011-07-19 at 06:30 pm

³⁷ cp. Ibid.

³⁸ Ibid.

³⁹ Dullien, Sebastian; Hansjörg Herr, Christian Kellermann; Decent Capitalism: A Blueprint for Reforming our Economies; p. 17

⁴⁰ Krugman, Paul; Maurice Obstfeld; International Economics: Theory & Policy; p. 568 f.

⁴¹ cp. Ibid.

⁴² Communication Department of the European Commission; http://europa.eu/legislation_summaries/economic_and_monetary_affairs/introducing_euro_practical_aspects/l25007_en.htm#KEY; access on 2011-07-19 at 06:30 pm

⁴³ cp. European Central Bank; http://www.ecb.int/ecb/history/emu/html/index.en.html; access on 2011-07-20 at 12:45 pm

⁴⁴ cp. Ibid.

⁴⁵ Ibid.

⁴⁶ cp. Dullien, Sebastian; Hansjörg Herr; Christian Kellermann; Decent Capitalism: A Blueprint for Reforming our Economies; p. 18 f.