Optimum Currency Area (OCA) Theory

Optimum capital Area (oca) TheoryWhat criteria did Mundell utilise to identify an optimum bullion familiarwealth and how relevant be these criteria straight off in deciding whether two countries constitute an optimum gold body politic?An Optimum money Area ( oka) is a geographical voice in which maximise economic efficiency is attained by the entire character sharing a single up-to-dateness (a pecuniary mating), or by several currencies pegging to each different via a fixed deputize rate. internal authorities have incur to the realisation that by merging with other countries to mete out a specie, everyone might benefit from gains in economic efficiency. An manakin of this can be seen in the formation of the euro where the countries involved do not individually match the criteria of an OCA, but believe that together they come close. The rail of national authorities is to establish the correct form of economic integrating to maximise efficiency.One of the orig inal fo chthonians of the OCA theory was economist Robert Mundell. In his first paper A Theory of Optimum bullion Areas (1961) he presented several principal criteria to create a functioning monetary union. To confine these criteria for an OCA I shall on occasion refer to an example of consumer preferences transformation from French to German- do products by Paul De Grauwe (2003). The change in consumer preferences will suit an upward raise up in aggregate take aim in Germany and a downward shift in France as shown in 1 below. The output gloam in France and increase in Germany is most seeming to campaign unemployment to increase in France but decrease in Germany.The first of the criteria for an OCA is price and lock flexibility throughout the geographical area. This means that the grocery forces of supply and demand automatically distribute money and goods to where they are needed. For example, with regards to France and Germany under perfect mesh flexibility, the unemp loyed workers in France will reduce their wage claims, and conversely excess demand for work in Germany will pressure up the wage rate. This inevitably shifts aggregate supply for France outwards devising French products more warring, and stimulating demand, whereas the opposite occurs for Germany. 2 below shows the nucleus of wage flexibility as an automatic adjustment mechanics.Mundell cited the importance of instrument mobility as an essential ingredient of a common currency (Mundell, 1961) and hence compass mobility across the geographical locality is one of Mundells main criteria for an OCA. In the incident of De Grauwes example, French unemployed workers would pretend to Germany where there is excess demand for labour. This free movement of labour eliminates the need to let fight decline in France and increase in Germany solving both the unemployment problem in France, and the inflationary wage pressures in Germany.The populateence of labour mobility relies on the kafkaesque supposals of free movement of workers among regions regard slight of physical barriers much(prenominal) as work permits, cultural barriers such as voice communication difficulties and institutional barriers such as superannuation transferrals. Indeed putz Kenen referred to the additional costs of prepare workers and there is an unrealistic assumption of perfect occupational mobility(Kenen, 1969). Ronald McKinnon observed that in practice this does not work perfectly as there is no true wage flexibility (McKinnon, 1979). McKinnon is simply highlighting the point that in reality wage flexibility, as well as perfect labour and capital mobility do not always exist. Considering a case where wages in France do not decline despite the unemployment situation (no wage flexibility), and French workers do not move to Germany (no labour mobility) both Germany and France would be stuck in the original position of disequilibrium. In Germany the excess demand for labour would pu t pressure on the wage rate, causing an upward shift in the supply curve. The adjustment from the position of disequilibrium would in this case come exclusively from price increases in Germany making French goods more competitive once more. Therefore if wage flexibility and labour mobility does not exist then the adjustment form will be entirely reliant on inflation in Germany.Mundell stated product diversification everywhere the geographical area is an important determinant of the suitability for a region to share a currency. This has been supported by many economists, such as Peter Kenen who says groups of countries with diversified domestic production are more likely to constitute optimum currency areas than groups whose members are super specialised (Kenen, 1969). lastly Mundell stated that an automatic fiscal transfer mechanism is required to spread money to sectors with adverse affects from labour and capital mobility. This usually takes the form of revenue redistribution to little developed areas of the OCA. Whilst this is theoretically persuasionl and necessary, in practice it is exceedingly difficult to get the well off regions of the OCA to give remote their wealth.Mundell produced two models in relation to OCA theory. In the first, under a model of Stationary Expectations (SE), he takes a pessimistic view towards monetary integration, however in his second paper he counters this, and focuses on the benefits of a monetary union under the model of world(prenominal) Risk sharing (IRS), which has conversely been utilise to argue for the forming of monetary unions.The Theory of optimal Currency Areas paper by Mundell in 1961 portrays OCAs under stationary expectations. The assumption is made that asymmetric shocks undermine the real economy and thus flexible turn rates are considered preferable because a shared monetary constitution would not be precisely tuned for the specific situation of each constituent region. This paper led to the fo rmation of the Mundell-Fleming Model of an open economy which has been used to argue against the forming of monetary unions as an economy cannot simultaneously plead a fixed turn rate, free capital movement, and an independent monetary policy.Whilst the Mundells criteria for an OCA is held in high regard my many economists, there are roughly criticisms levelled at him. Capital mobility is seen to have been a greater adjustment mechanism than labour mobility (Eichengreen, 1990) and this is a factor John Ingram criticises Mundell for ignoring. Clearly the openness of the region to capital mobility is crucial to the makeup of an OCA, as for trade to exist in the midst of participating regions, free movement of capital is necessary.However in the age that followed his 1961 paper on OCAs Mundell realised the criticisms of his previous paper and began to doubt the elementary argument for flexible change rates as an adjustment mechanism. He became more appreciative of the adjustmen t mechanism under fixed exchange rates, It was not that I had forgotten the Mundell-Fleming model, but that I had gone beyond it (Mundell, 1997). In Mundells 1973 paper, Uncommon Arguments for joint Currencies, he discarded his earlier assumption of static expectations to look at how future uncertainty about the exchange rate could disrupt the capital markets by restraining world(prenominal) portfolio diversification and risk-sharing. hither he introduces his second model of OCAs under IRS. He counters his previous idea that asymmetric shocks weaken the case for a common currency by suggesting that a common currency can reduce such shocks by sharing the burden of loss. He uses the example of two countries, Capricorn and Cancer. In spring, Cancer ships half of its crop to Capricorn and in return it receives secernate of Capricorns debt, a claim to half of Capricorns food crop in autumn. fleck one country is expanding its money supply and running a correspondence of payments surp lus, the other will be running a balance of payments deficit, and the process is reversed during the next period.Mundell points out that this system is very satisfactory in a orbit of certainty, however in reality there is shot about the convertibility of foreign currencies. If Cancer had a bad harvest and produced less crop, to redeem all of notes from the Capricorn would involve providing them with their promised share of crop as usual, leaving Cancer little(a). The only defence against paying out the promised share of crop would be a devaluation of Cancers currency and thus a reduction in the claim by Capricorn on the crop. Capricorn take to get enough crops to survive and produce food in the autumn, so Cancer will not too be left short on supplies in the next period. The solution would appear to be a partial devaluation of Cancers currency, so that the burden of loss would be shared among the two countries.Mundell has shown that with different currencies comes the uncerta inty of devaluation, a problem which a common currency would not have. Under a common world currency if Cancer has a bad crop the total amount of world currency will exchange for full quantity of crop, irrespective of who holds the money as competition and freedom of arbitrage assures a single price. So long as competition exists, and there are no eon lags in the transmission of goods or information, the price of the food will evolve for both countries and so the burden of shock is shared automatically and equally by the two countries.To reconcile Mundells two papers and assess the appropriateness the criteria on determining two countries suitability as a currency area I have decided to look at the case of the europiuman Monetary sum (EMU) and its success as a monetary union.There are many examples of countries within Europe that would struggle to maintain international competitiveness without the currency area. The areas of the EU with low labour mobility are furthest away fr om meeting the criteria of a currency area. However, while the remotion of legal barriers (such as visas) has improved this labour mobility, issues such as language barriers remain, for example, a French worker may not wish to move to Spain because they cannot speak Spanish, also people tend to have ties to the places they currently travel and may not be willing to move away from them. Bayoumi and Eichengreen (1992) compared the US and Europe with respect to how disturbances in separate regions match shocks in a selected benchmark region. They chose Germany as the benchmark for Europe and found that there is a relatively high symmetry of disturbances within the core of the EU such as Austria, Benelux, Denmark, France and Germany. They also found that the symmetry was lower for western European countries. When compared to the USA, the EMU had a higher probability of asymmetric shocks. However match to Fidrmuc and Korhonen (2001) the extent of the asymmetric shocks is declining in t he EU economies. Bayoumi and Eichengreen believe that countries within Europe are further from an OCA than regions in the USA, and so are less appropriate as a currency area. These studies suggest that two countries in the EU are less suited to forming a monetary union than the regions of the USA, although the situation is improving. Frankel and flush (1998) argued that the higher the trade integration, the higher the correlation of the condescension cycles among countries, in other words there is greater symmetry of shocks. They also propose that transmission line cycles and trade integration are inter-related and endogenous processes to establishing a currency union. Frankel and Roses empirical findings noted that EMU entry encourages trade linkages among countries and causes the business cycle to be more symmetrical among the unions participants. Rose and Stanley (2005) find that a common currency generally increases trade among its members between 30% and 90%. These findings agree with Mundells argument that a common currency can suspensor to deal with asymmetrical shocks. Frankel and Roses findings suggest that although two countries considering creating a common currency may not meet the criteria before they join the currency area they may do afterwards.Economists are divided in opinion between Mundells two OCA models. The contrasting views which Mundell presents in his papers have get him a title as the intellectual father to both sides of the postulate. While some economists support the theory of stationary expectations, preferring flexible exchange rates, and conclude against the euro, others advocate the IRS model, preferring the fixed exchange rate, and conclude in privilege of the euro. Mundell himself seems to have eventually settled in favour fixed exchange rates in a monetary union however he does still advocate the use of flexible exchange rates in two cases. In the case of unstable countries, whose inflation differs significant from its currency sharing regions and in large countries where there is no established international monetary system, e.g. the USA. From Mundells studies I can conclude that two countries which are intemperately integrated through highly mobile factors of production which are highly diversified in their goods should join a common currency. With regard to the relevancy of Mundells theory today I would say his studies are still sound and used heavily as complementary theory to monetary integration occurring in Europe and throughout the world.ReferencesRobert MundellA Theory of Optimum Currency Areas, 1961Uncommon Arguments for Common Currencies p. 115, 1973A Conference on Optimum Currency Areas at Tel-Aviv University, 5th December 1997Paul De GrauweEconomics of Monetary Union p. 7, 2003)Robert McKinnonMoney in International Exchange The Convertible Currency System, 1979Peter KenenThe theory of Optimum Currency Areas an Eclectic view, 1969Monetary Problems of the International Economy, 1969, pp. 95-100Barry EichengreenOne Money for Europe? Lessons from the US Currency Union, 1990Is Europe an Optimal Currency Area, 1991J. Fidrmuc I. KorhonenSimilarity of supply and demand shocks between the Euro area and the CEECs, 2001J. A. Frankel A. K. RoseThe Endogeneity of the Optimum Currency Area Criteria pp. 1009-25, Jul 1998A. K. Rose T. D. StanleyA Meta-Analysis of the Effect of Common Currencies on International Trade, pp 347-365, 2005