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The Cost and Benefit Analysis of an Optimum Currency Area

MSc Banking and International Finance (2013-2014)

Toulouse Business School

Author- Akash Baruah

Research Guide – J.F Verdie

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Abbreviations:

OCA – Optimum Currency Area

BOP- Balance of Payment

Introduction:

A Currency area is said to be optimal when they satisfy the basic

conditions of price stability, full employment and a positive BOP balance,

if this is not such a case, then the currency regime is not said to be

optimal. There also has to be symmetry in shocks and flourishing trade

within the union (positive BOP with the OCA). An Optimum Currency Area

can only be formed when the very economic structure of the countries in

consideration of forming the Union are same. This is important for better

integrated intra-industry trade, smoother labour movement and for the

symmetry of shocks to be felt across the states in time of a crisis. `There

should be significant amount of trade among the proposed countries, for

them to reap the benefits of an Optimum Currency Area. (Kenen 1969)

argues that the better diversified an economy is, the least it is bothered

about asymmetric shocks and exchange rate regimes. Thus diversification

of an economy can be considered an important point before forming an

OCA. Even there should be trade diversification within the OCA and

greater amount of trade should be within the domain of the OCA.

Adjustment cost in the Balance of Payment should be reduced and the

transformation process from one business cycle to another should be

much faster.

A trade off between inflation

and unemployment, both are utterly unacceptable for the welfare of the

population within the OCA, which is the primary reason for forming it.

Thus there has to be a mechanism to reduce the adverse effects of

shocks on both the phenomenon and to speed up the recovery process

more than which otherwise would have been possible without an OCA. In

this dissertation of mine, I have tried to highlight and discuss some of the

issues involved in forming a Monetary Union and how to make that union

an Optimum Currency Area. While addressing these issues, I have

explained the fundamental causes and also provided some probable

solutions to the problem. There are many costs and benefits in forming a

Monetary Union and the integration of nations should be mainly to reap

the benefits out of it.

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Contents:

1. Cost

1.1 No exchange rate devaluation 4

1.2 Asymmetry of shocks 5

1.3 Specialization 6

1.4 No demand adjustment by Inflation 6 - 7

2. Benefits

2.1 Reduction in transaction cost 7

2.2 Greater price stability 7 - 8

2.3 Labour mobility 8 - 9

3. Suggestions

3.1 Single Fiscal Policy 9 - 10

3.2 Balance of payment monitoring and Import directives by the Central

Union 11

4. References 12

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1. Cost

1.1 No exchange rate devaluation

If there is an increase in the money supply in the home country within a

monetary union due to the fiscal policy, which leads to an increase in

demand for goods, should lead to an increase in prices to maintain

equilibrium or increase the supply side measure to maintain the

demand. If the supply side measure cannot be adequately restored,

there would be massive disequilibrium in the economy as the prices of

goods cannot be raised to absorb the excess demand in one of the

member states, If the demand in the whole of the union is stable. In this

situation the aggrieved member state will have to import goods in order

to maintain demand and in the process run up huge current account

deficits. Thus the aggrieved state should devalue its currency to restore

competitiveness and increase its exports, but it cannot do so in a

Currency Union. It suffers a lot in the process of restoring its economic

condition with such constraints. The situation forces the aggrieved

state into huge current account deficit and results in Governments

taking austerity measures to reduce demand and even massive

unemployment. The Phillips curve provides us with great insight in this

regard. Therefore there has to be harmony between the fiscal and the

monetary policy, which is very hard to achieve in a Monetary Union.

Due to this the rate of transformation of the aggrieved economy to

restore its competitiveness is a very painful task and comes with a lot

of price.

If the real

income increases with the rise in money supply due to fiscal policy, as

the inflation is fixed, this will result in the increase in demand for money.

Thus to reduce the demand of money and goods there has to be a hike

in the interest rates. To restore the Balance of payment position also,

the interest rates should be raised to increase the capital inflow in the

capital account. But due to the Monetary Union, interest rates cannot

be hiked in order to reduce the deficit and increase the inflation.

The situation

becomes even more adverse when the foreign price level falls further in

comparison to the home currency. This makes it even more difficult for

the member state to increase its exports, as it cannot devalue its

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currency, neither can it raise interest rates and the mounting current

account deficit pushes the state into deep recession.

1.2 Asymmetry of shocks

The assumption of sharing shocks across the member states in times of a

crisis is proven to the contrary (Greece, Spain, and Portugal) and even the

free movement of labour, as there is high degree of unemployment in many

European countries, which is the only legitimate Monetary Union in the world

at the present situation. (Fernando 2004) Financial integration can be

achieved when all the market participants have the same set of rules in terms

of the financial instruments, when all the participants are treated equally and

when all the participants have equal access to the financial instruments.

Unification of the financial market should provide an insurance against the

asymmetry of shocks felt, which is not at all true and is well proven by the

aftermath effects of the Lehman crisis. Different investor behaviour in different

countries is a strong reason for this. This requires an even more specific

financial integration. Thus the assumption of the reduction of cost of a

monetary union through this is utterly unfulfilled. Financial integration is very

important to be achieved along with banking unification for a monetary union

to become an Optimum Currency Area. Otherwise there will be massive

unemployment and economic recession.

Non integration of the

financial market and different credit allocation policies by different countries

and also specialisation of countries, can lead to massive asymmetry in the

shock absorption across the OCA. Different credit allocation policies adopted

by banks can lead to causing bubbles in certain sectors and hence make

countries prone to specific financial crisis.

An asymmetry of shock in a

member country can cause huge deficit and crisis in that country. If the

government to reduce deficit levies more tax on the companies, there will be

either reduction of wages or massive unemployment in order to maintain the

competitiveness of the single market.

Due to the creation of an

OCA and a single market, all the member countries will be very highly

positively correlated with financial crisis and if there is no proper financial

integration, a single financial crisis will result in massive asymmetry in shocks

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and the aggrieved countries will find it very difficult to come out of the crisis by

staying inside the OCA.

1.3 Specialisation

(Kalemli-Ozcan, Sorensen, Yosha-2003) Economic integration leads to better

risk sharing opportunities and hence increases the incentive for specialisation

which in turn affect the symmetry of macroeconomic fluctuations, in turn

makes the shocks more asymmetric. Economies of scale, plays a part in it.

(The case of Germany can be highlighted with its specialisation in the

Automobiles Industry). Therefore increase in the specialisation is a benefit for

the OCA and the increase in asymmetry of shocks is a cost for the OCA, there

has to be a systematic trade off between these two.

As the member states should converge

more towards similar kind of economies and engage in similar activities,

reduction in trade barriers provide incentives for the member states to

specialise. This in turn makes the economies to polarise and cause significant

discrepancies during financial crisis and cause a lot of hindrance during

labour mobility.

(Fidrmuc 2004) intra-industry trade gives

rise to symmetry of shocks and more correlation of income and output, where

as inter-industry trade results in more specialization and increases the cost of

a monetary union. Therefore more focus should be given in developing the

member states in such a way that intra- industry trade flourishes and similar

kind of industries develop. Increased trade integration eventually may lead to

decrease business cycle synchronisation as the economies more try to

converge towards specialisation and thus increases the chance of an

asymmetry of shocks felt on the event of a financial crisis.

1.4 No demand adjustment by Inflation

In case of an increase in demand due to a fiscal policy, the excess demand

cannot be absorbed by creating inflation through monetary money supply. In a

Currency Union the banking system will be centralised and inflation cannot be

allowed to rise for the demand adjustment in just one member state. When a

member state is in such a situation, it only has the option of unemployment,

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which takes away the prosperity of its people. The growth rate of an economy

declines as the companies reduce production, income falls and leads to

massive unemployment. This is a very significant cost of a Currency Union

which makes the adjustment cost of an aggrieved state very high.

2. Benefits

2.1 Reduction in transaction cost

Forming a Monetary Union reduces currency transaction costs

considerably, provided the proposed countries within the monetary union

has considerable amount of trade within them. Not all the costs of a

foreign currency cost could be saved by the use of a single currency.

Some foreign currency loans are taken for hedging purposes and some

are taken in the order to reduce the cost of borrowing. Only the cost

associated with the risk of hedging or opportunity cost can be saved from

the use of single currency.

Some costs associated with

foreign trade are huge amount of rents extracted by Banks, Intermediaries

and currency dealers. They are able to earn huge amount of money

through economies of scale, which they achieve due to the large scale

transactions that they handle. large scale currency conversions involve a

bid ask spread, which in relations to trade between countries amounts to

huge costs which could be saved by a monetary union.

2.2 Greater price stability

Due to the creation of a single currency there will be greater inflow of FDI

and capital inflows, both from within the Monetary union and also from the

rest of the world as generally there will be a sense of lower volatility and

stability on the new currency as well as the external purchasing power of

the new currency will also increase. This will lead to the formation of an

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overall optimism towards the OCA. Due to a common rate of inflation

achieved in an OCA, the spread across government bonds within the

OCA reduces to a great extend and result in lower volatility and

strengthening of stability.

With greater price stability, the cost of

uncertainty is also reduced. Thus trade and investment flourishes when

there is certainty and confidence in the environment. This leads to overall

development and growth of the Monetary Union and provides a platform

for the people to move towards prosperity.

2.3 Labour Mobility

Due to the convergence of inflation rate across the OCA, there will be

stability in prices. Due to a very competitive product and price market and

due to longer contracts of labour employment, there will be stability in the

labour market wages. Thus if a crisis occurs within the Currency Area or

in any member state, labour can now move freely from one state to

another. This is also largely possible due to the economic and financial

integration within the OCA and the similar economic structure that they

posses.

Even if the labour is mobile within an

optimum currency area, the movement of labour from the affected country

to an unaffected country is not always possible and besides if more and

more labour moves out, there would be labour scarcity in the home

country, thus giving rise to high labour cost and reduction in firm

productivity. The percentage of imported goods in the living index is a

thing of concern, the more an economy is able to produce goods

indigenously, the less will be the impact of devaluation and labour

adjustment will be smooth. The structure of an economy again affects

directly to the mobility of labour. For a smooth transition of labour the very

structure of the economies should be the same.

Thus in a fixed exchange rate regime

when foreign price level falls, there will be higher demand for foreign

goods, fall in prices and unemployment. The foreign exchange reserves

will fall and the home currency needs to be depreciated. But in a Monetary

Union the transition phase can be much smoother with very low rate of

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unemployment, as labours can easily move from one place to another

within a union. The burden of adjustment in such a case is not only to be

borne by the labour unemployment. But the only precondition for this is

that, economic structures of the countries within the union, has to be

similar.

3. Solutions

3.1 Single Fiscal policy

All the problems of demand caused by the increase in money supply due

to domestic fiscal policy, asymmetry of shocks and speedy recovery from

crisis can all be achieved from a single fiscal policy, which should be

formed for the whole of the union.

If due to a sudden crisis, labour

starts to move from the aggrieved country to a new member state, than

again there would be surge in the prices of the labour market and hence

the cost of production of factories would rise. This would create a

manufacturing and production bottleneck and hinder the growth of the

aggrieved member state. Too much of labour movement is anti-growth. A

particular fiscal policy is very necessary for the whole of the Union and

other fiscal policies of the member states have to be in alignment with the

central fiscal policy.

The after effects of a financial crisis

will always bring about depression and slow economic growth and

unemployment and this will also be the case within an OCA, but our

efforts should be to make the transformation much faster, faster than

within a normal flexible exchange rate area. This requires a single fiscal

policy within the area and more cooperation amongst the member states

to adjust the demand of the aggrieved state and also its BOP position.

Financial Integration should increase and structural reforms should be

taken to reach optimality.

Increasing

the money supply in the aggrieved region can also possibly be a way to

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reduce the demand shock and causing a bit of inflation in that region. If

the overall inflation cannot be increased for a few countries, than there

has to be a single policy and better financial integration to spread the

shocks across the regions.

In an OCA there should be

similar kind of activities, same financial integration and same growth

possibilities and should be governed with a single fiscal policy if possible.

Banking harmony is of utmost important. Credit allocation should also be

taken care of. Specialisation is very dangerous for an OCA and therefore

the single fiscal policy should always aim at balanced development.

If the demand is over powering the

equilibrium in an economy, then the supply side constraints can be

removed by providing subsidies to the companies to carry on with their

production and in turn help create more jobs. Now again this cannot be

undertaken by the same aggrieved economy government, but has to be

done through a single fiscal policy, which is done by a Central

Government of the monetary Union. A federal structure of Government is

very necessary in a Single Currency Area to become an OCA.

When starting of an OCA, even if

there are discrepancies in the economic structure of the different member

states, the single fiscal policy should try to highlight these problems and

make the policy incline towards making these discrepancies disappear

and approach towards attaining a more balanced production and

economic structure. This would later help in smoothing the asymmetry of

shocks, smoother mobility of labour and help attain the goal of an OCA.

The independent countries would take their own specialisation and own

internal lacking into account, which needs to be improved and make fiscal

policies according to their specifications. But the wholesome development

of the Currency Area, with balanced development and more convergence

towards similar economic integration has to be done by a Single fiscal

policy adopted by the Central Government of the Union.

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3.2 Balance of Payment Monitoring and

Import Directive by the Central Union

The BOP Position of a country with the rest of the OCA should

always remain positive, for the very survival of the fundamentals of an

OCA. Openness of an economy and economic integration should always

bring about a positive BOP so as to get the benefits of an OCA. The cost

of isolating itself from the rest of the world should be very well be

compensated by a positive BOP with the rest of OCA. It can surely be

highly surplus, but has to maintain a minimum surplus. The Global BOP

position can be negative and in such a case, it should be helped to

recover by the other member states, by importing from the aggrieved

country and reducing the deficit.

If there is a BOP crisis for a country

due to the increase in imports and more precisely a current account deficit,

it can’t devaluate the currency to increase its exports. But the adjustment

has to be done by raising taxes. It can’t even raise taxes on people due to

political constrain and thus have to raise corporate tax, which in return

results in decrease in the supply side measure, adding to the supply side

constrain. The situation becomes more and more complicated if it is

borrowing within the member states and it can’t increase exports to

outside member states by reducing the value of its currency. There should

be directive given by the Central Commission to other member states, to

import certain goods from the aggrieved member state and not from

others. There might be a scenario that a country is very heavy on import

side, but the monetary union as a whole is having a surplus in BOP, that

might cause a severe constrain on the home country to recover. On the

contrary if a country is having a huge amount of surplus in its BOP and

thus the country will be in a very favourable situation and will grow

stronger if the inflation and price level does not go up. Thus there has to

be complete harmony within the member states to give ample and equal

opportunity to all.

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4. References:

Laurence .S. Copeland, 2005, “Exchange Rates and International

Finance”, Fourth Edition, Essex, Pearson Education limited, 500,

0273-683063

Ferrando, A, Baele, L, Hordahl, P, Krylova, E, Monnet, C, 2004,

“Measuring financial integration in the euro area”, ECB

occasional paper no. 14, April.

Fidrmuc Jarko, 2004, “The endogeneity of the optimum currency

area criteria and intra-industry trade implications for EMU

enlargement” in Paul De Grauwe and Jaques Melitz (Eds)

Monetary Unions after EMU, MIT Press, Forthcoming.

Frederic .S. Mishkin, 2004, “The economics of Money, Banking

and Financial Markets”, Seventh Edition, United States of America,

Pearson, 679, “The Adission Wesley series in economics”, 0-0321-

12235-6.

Kalemli Ozcan, Sebnem, Bent.E. Sorensen, Oved Yosha, 2003,

“Risk sharing and industrial specialisation: Regional and

international evidence”, American Economic Review June 2003

93(3).

Kenen, Peter, “The theory of Optimum Currency Areas: An

Eclectic view” in Mundel and Swoboda (Eds) Monetary Problems

in the international economy, University of Chicago Press, 1969.

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