The Concept of an Optimum Currency Area - Literature review Example

? Is Europe an Optimum Currency Area? - A Literature Review of the of the Concerned 4 May An Optimum Currency Area or an Optimal Currency Region are the terms used to refer to such a geographical zone where the sharing of a single currency by the entire region leads to the maximization of economic efficiency (McNamara 1999). The economists have been studying the types of currency regimes and their impact, since decades. The European Economic and Monetary Union have facilitated a virtual playing field to the interested economists to delve on the possible implications and effects of Optimum Currency Areas (McNamara 1999)). This phenomenon has allowed for a vantage point to the economists from where they can try understanding the possible problems and difficulties associated with economic integration. The objective of this literature review is to understand the criteria essential to the achievement of Optimum Currency Areas in the light of the existing academic sources and theories. This literature review also intends to understand whether the European Economic and Monetary Union are gradually shifting towards an Optimum Currency Area position. It is Robert Mundell who is attributed to be the pioneer of the theory of Optimum Currency Area. Vasiliauskaite and Vitakauskas (2007) have successfully identified certain criteria delineated by Mundell to be necessary for the existence of a viable currency union. As per Mundell, for a region to move towards an Optimum Currency Position, the labour mobility is a necessary and pivotal requirement (Vasiliauskaite & Vitakauskas 2007). The labour mobility in this context includes the physical ability and possibility on the part of the labour in a region to move from the depressed areas to the propitious ones. This mobility criterion also entails an absence of the cultural and political barriers to labour mobility and the existence of viable institutional mechanisms to facilitate mobility of labour (Vasiliauskaite & Vitakauskas 2007). Besides, According to Mundell, the monetary union in a region required an integration of the financial markets of the member nations accompanied by a total flexibility of prices and wages across the region (Vasiliauskaite & Vitakauskas 2007). Also, Mundell tagged to these criteria the need for a regional political integration making way for the fiscal transfer mechanisms for the redistribution of capital around an Optimum Currency Area (Vasiliauskaite & Vitakauskas 2007). Besides, it is also imperative that most of the nations in an Optimum Currency Area have diversified economies and similar business cycles (Vasiliauskaite & Vitakauskas 2007). Vasiliauskaite and Vitakauskas (2007) have concluded after an elaborate analysis of the existing data that though the European Economic and Monetary Union does qualify many of the criteria considered by Mundell to be essential for the creation of an Optimum Currency Area, the labour mobility in the European Union is much constrained as compared to USA. In Europe there exist many cultural and economic barriers that hamper the hassle free mobility of labour. Also the European Union, unlike America, cannot rely on Fiscal Federalism to iron out the regional economic disturbances (Vasiliauskaite & Vitakauskas 2007). In his seminal work in the context of the Optimum Currency Areas that is A Theory of Optimum Currency Areas (1961), Mundell discernibly appears to adhere to a Keynesian mindset. According to Mundell, in order to mitigate the shocks occurring in the private sector, whether originating from the supply side or demand side, the countries could resort to the manipulation of national fiscal and monetary policies (1961). This nascent theory of Mundell was essentially based on stationary expectations pertaining to exchange rates, price levels and interest rates. The earlier Mundell was conclusively all for the Keynesian fine tuning of national fiscal and monetary policies, shielded by a floating exchange rate (1961). Mundell held that the diversified economies placed in large currency areas were always vulnerable to asymmetrical macroeconomic shocks (1961). Thus, as per Mundell, under such circumstances, if such economies resorted to fixed exchange rates, then they would not be in a position to customize or tailor their monetary policies so as to offset asymmetrical shocks (1961). Thus, Mundell in his initial works strongly supported a flexible exchange rate. He held that a flexible exchange rate was always open to adjustments necessitated by the domestic or foreign monetary policies and per se was not a cause of any disturbance. However, the volatile exchange rate fluctuations in the 70s blatantly challenged this theory. Though, there is no denying the fact that a great number of economists are still in thrall to Mundell’s earlier theory, yet he published a paper in 1973, Uncommon Arguments for Common Currencies, that favoured a unification of the diverse economies through a common currency. In this new theory Mundell explained that within a single currency region, the asymmetrical shocks were more readily offset, without any need for the fine tuning of domestic monetary or fiscal policies (1973). As per Mundell, in a common currency domain, a country open to an unfavourable shock could easily rely on a trading partner for sharing the concomitant loses, as both the countries had a claim on eachother’s output, because the shared a common currency (1973). In his later avatar, Mundell declared that a reasonably fixed exchange rate backed by an integration of the capital markets allowed for a feasible risk sharing amongst nations through portfolio diversification (1973). Here, Mundell holds that provided the exchange rates are fixed, the international capital markets provide an efficient mechanism for risk sharing. Ronald McKinnon (2002) revisits both the earlier and later theories of Mundell by deconstructing them. As per McKinnon, Mundell’s earlier theory fails to elaborate on the possibility of managing exchange rates through mutual cooperation amongst nations (2002). McKinnon points to varied academic endeavours that concluded that without capital controls, floating exchange rates were always open to vulnerability (2002). This volatility got further aggravated by the possibility of two trading partners following diverse monetary policies. A country simply cannot divest its monetary policy from a trading partner, in the presence of a forward looking floating exchange rate (McKinnon 2002). McKinnon believes that in the absence of a common currency, it is natural to find asymmetries amongst the currencies of varied nations in a region (2002). In a common currency domain, the financial intermediaries dealing in the bonds market feel less constrained as they are not required to chalk out separate strategies for domestic and foreign currency liabilities (McKinnon 2002). Usually the financial intermediaries tend to have a home bias owing to the possibility of currency risk. However, the amelioration of the currency risk owing to a common currency allows them to opt for a diversified international portfolio (McKinnon 2002). Besides, a common currency mitigates the possibility of asymmetric shocks by diversifying and increasing trade (McKinnon 2002). Yet, the cause of opting for a common currency is directly dependent on the costs associated with this objective (Socol 2011). The one visible cost of adhering to a common currency is that the involved nations are required to give up their hold on domestic monetary policy. So the nations in any region will tend to be open to the idea of a common currency only if the benefits of a monetary union happen to be more lucrative than the involved costs (Socol 2011). Based on these facts, it is possible to conclude that eventually European Monetary Union may evolve into an Optimum Currency Areas. Still, much needs to be done before this possibility becomes a reality. Eventually a lot is dependent on the possible costs of participation associated with the specific members. Reference List McNamara, Kathleen R 1999, The Currency of Ideas: Monetary Politics in the European Union, Cornell University Press. McKinnon, Ronald 2002, ‘Optimum Currency Areas and the European Experience’, Economics of Transition, Vol. 10, no. 2, pp. 343-364. Mundell, Robert A 1962, ‘A Theory of Optimum Currency Areas’, The American Economic Review, Vol. 51, no. 4, pp. 657-665. Mundell, Robert A 1973, ‘Uncommon Arguments for Common Currencies’, in Johnson, AG & Swoboda, AK (eds.), The Economics of Common Currencies, Allen & Unwin, London, pp. 114-132. Socol, Aura Gabriela 2011, ‘Costs of Adopting a Common European Currency. Analysis in Terms of the Optimum Currency Areas Theory’, Theoretical and Applied Economics, Vol. 18, no. 2, pp. 89-100. Vasiliauskaite, Asta & Vitakauskas, Mindaugas 2007, ‘The Attainability Analysis to Complete Requirements of Optimum Currency Area within EU’, Economics and Management, Vol. 12, pp. 261-268 Read More