b. Suppose that based on the OCA, Country A and Country B join the CU but
Country C does not. Illustrate the OCA line on your diagram based on this
information.
Answer: See the previous diagram. Country A and Country B lie above the OCA
c. Suppose that Country A decides to maintain a fixed exchange rate against the
CU’s currency. Is it possible that it is optimal to do so, even if it is not optimal to
join the CU currency union? Explain why or why not and illustrate the
appropriate FIX line on your diagram.
3. In a symmetry‒integration diagram, illustrate how each of the following scenarios
affects the position of the OCA line and the likelihood that a given country (Country
A) will join the currency union. Assume that Country A starts off as indifferent
between joining a currency union versus keeping its national currency.
a. The currency union adopts a program of fiscal transfers to alleviate output losses
in regions experiencing recession.
Answer: The introduction of fiscal transfers will mean that countries can rely on
b. The new chair of Country A’s central bank announces she is committed to
reducing the inflation rate from 3% to 2% over the next year. The inflation rate in
the currency union is currently 4%.
Answer: See the following diagram. One of the economic benefits of joining a
c. The currency union admits a new country, Country B, that has a higher inflation
rate than other countries in the currency union.
Answer: See (b) and the previous diagram. If the currency union admits countries
d. Negotiations between Country A and the currency union lead to the adoption of a
new program that creates uniform labor market regulations across the region.
Answer: Increased labor mobility reduces the stability costs associated with
e. Leaders in Country A and the currency union countries decide to form a military
alliance against another region.
Answer: This alliance increases the political benefits of joining the currency
4. Consider the data presented in panels (a) and (b) of Figure 21–4 from the text in the
context of a symmetry‒integration diagram. For this question, you may assume the
FIX and OCA lines are straight (linear) and not curved (nonlinear).
a. Create a symmetry‒integration diagram. Label the axes according to the measures
Germany, Ireland, the Netherlands, and the United Kingdom.
Answer: See the following diagram.
b. Among the countries given in (a), all are members of the Eurozone except for the
United Kingdom and Denmark. Denmark maintains a peg against the euro, but the
United Kingdom does not. Based on your diagram, is it possible that both
Denmark and the United Kingdom are making the decision to fix versus float
based on the OCA? Explain.
c. On your diagram, draw a FIX line that assumes Denmark and the United
Kingdom are making an optimal decision to fix versus float.
d. On your diagram, draw the OCA line such that only Germany and the Netherlands
would join the Eurozone. Label this line OCA1.
e. On your diagram, draw the OCA line such that all of the countries mentioned
previously would join the Eurozone. Label this line OCA2.
f. Looking over your diagram, which three countries are least likely to seek
membership in the Eurozone based on the OCA criteria? Based on the
information given in (b), is this consistent with reality?
Answer: It appears that Estonia, Ireland, and the United Kingdom are least likely
g. What types of events or changes would shift the OCA line inward from OCA1 to
OCA2? Explain.
Answer: There are several factors that could shift the OCA line inward from
5. In June 2003, former Prime Minister Gordon Brown informally proposed “five tests”
for U.K. membership in the Eurozone. They are as follows:
(1) Are business cycles and economic structures in Britain compatible with European
interest rates on a permanent basis?
(2) Is the British economy flexible enough to quickly adjust to shocks that arise
within the system?
(3) Would joining the euro attract more long-term business investment into the
United Kingdom?
(4) What impact would entry into the euro have on the United Kingdom’s
competitiveness in the financial services industry?
(5) Will joining EMU promote higher growth, stability, and a lasting increase in jobs?
The IMF claimed these tests to be “broadly consistent with the economic
considerations that are relevant for assessing entry into a monetary union.” Based on
the OCA criteria studied in this chapter, do you agree with Gordon Brown and the
IMF? Explain why or why not, citing the OCA criteria.
Answer: See the following comments on each of the five tests:
(1) Are business cycles and economic structures in Britain compatible with European
interest rates on a permanent basis?
(2) Is the British economy flexible enough to quickly adjust to shocks that arise within
the system?
This has to do with labor market mobility. Capital markets are more efficient in that is
(3) Would joining the euro attract more long-term business investment into the
United Kingdom?
This test can be interpreted loosely in terms of the efficiency gains from increased
(4) What impact would entry into the euro have on the United Kingdom’s
competitiveness in the financial services industry?
London serves as an important hub for services to businesses and finance companies
(5) Will joining EMU promote higher growth, stability, and a lasting increase in
jobs?
The final test speaks directly to the possible efficiency gains from Eurozone
6. Consider the claim that the OCA criteria are self–fulfilling. In what ways might this
benefit a country that joins the currency union even if it doesn’t satisfy the OCA
criteria before joining? In what ways might this prove costly for a country even if it
does satisfy the OCA criteria before joining the union?
Answer: Potential effects on efficiency gains associated with joining a currency
7. Looking at the evidence, is the EU an optimum currency area? Reviewing a broad
history of Europe, do you believe the impetus for the formation of the EU and
Eurozone was economic or political? Explain.
Answer: Based on the economic OCA criteria, it is unlikely that the EU is an
8. Suppose the country of Petria is seeking membership in a currency union, the CU,
that uses a currency unit called the curo. The exchange rate is currently 2 Petrian
dollars per curo. Petria’s inflation rate is 7% versus 4% in the three CU countries with
the lowest inflation rates. The world real interest rate is 2.5%. Assume the CU uses
the Maastricht Treaty convergence criteria.
a. Using the UIP condition and the definition of the real interest rate, calculate the
expected depreciation in the Petrian dollar (relative to the curo).
Answer: From the UIP:
b. Does the country of Petria meet the nominal convergence criteria? Which ones
does it satisfy? Which ones are not satisfied? Explain.
Answer: Petria satisfies only one of the three convergence criteria. Because the
ERM band allows for ±15% change in the exchange rate, Petria is well within this
c. Suppose that Petria reduces its inflation rate to 3.25% over the next few years and
its nominal interest rate declines to a value consistent with this inflation rate
(according to the Fisher effect). Will it satisfy all the nominal convergence criteria
in this case? If not, which criteria are not satisfied?
Answer: It will satisfy the nominal interest rate criterion, but not the inflation rate
d. Suppose instead that Petria experiences an economic recession, causing its
deficit/GDP ratio to rise to 4%. In your opinion, what is Petria’s appropriate
response? Explain.
Answer: This problem highlights the difficulties with the fiscal discipline criteria
in the Maastricht Treaty. If Petria’s deficit/GDP ratio rises to 4%, then it no
e. How might your answer to (d) differ if Petria were already a member of the CU?
How does this relate the effectiveness of the SGP in Europe?
Answer: If Petria is already a member of the CU, it might opt to “cheat” by
ignoring the fiscal discipline criteria during recessions or periods of slow growth.