21 The Euro
Notes to the Instructor
Chapter Summary
This chapter examines the theory of optimum currency areas, focusing on the Eurozone
or Euro area. The chapter provides a historical background on Europe to better
understand the euro’s origins. It then develops the theory of optimum currency areas and
applies this theory to the ECB and Eurozone before considering the practical mechanics
of the monetary union in Europe. The chapter concludes with a preliminary evaluation of
the euro, identifying its potential benefits and weaknesses as it continues to expand.
Comments
This chapter provides a descriptive presentation of the Eurozone, relying on a
nontechnical presentation of the theory of optimum currency areas. This chapter can
follow naturally from Chapter 19 or 20. Students will need to have a good understanding
of fixed versus floating exchange rate regimes and general macroeconomic theory, but
they will not need the material in Chapter 20, whose outline follows:
0. Introduction
i. The Ins and Outs of the Eurozone
1. The Economics of the Euro
a. The Theory of Optimum Currency Area
b. Simple Optimum Currency Area Criteria
c. What’s the Difference Between a Fix and a Currency Union?
d. Other Optimum Currency Area Criteria
i. Labor Market Integration
ii. Fiscal Transfers
iii. Monetary Policy and Nominal Anchoring
iv. Political Objectives
e. Application: Optimum Currency Areas: Europe Versus the United States
i. Goods Market Integration
ii. Symmetry of Shocks
iii. Labor Mobility
f. Are the OCA Criteria Self–Fulfilling?
g. Summary
h. Headlines: Currency Unions and Trade
2. The History and Politics of the Euro
a. A Brief History of Europe
i. Back from the Brink: Marshall Plan to Maastricht, 1945–91
3. Eurozone Tensions in Tranquil Times, 1999–2007
a. The European Central Bank
i. Criticisms of the ECB
b. The Rules of the Club
i. Nominal Convergence
ii. Fiscal Discipline
iii. Criticism of the Convergence Criteria
c. Sticking to the Rules
i. The Stability and Growth Pact
4. The Eurozone in Crisis, 2008–13
i. Boom and Bust: Causes and Consequences of an Asymmetrical Crisis
ii. The Policymaking Context
iii. Timeline of Events
iv. Who Bears the Cost?
v. From Double Dip to Brexit and Beyond…
a. Headlines: A Bad Marriage
5. Conclusions: Assessing the Euro
i. Euro-Optimists
ii. Euro–Pessimists
iii. Summary
Lecture Notes
In this chapter, we examine currency unions in theory and in practice. The chapter begins
with an overview of the euro, and goes on to develop a theory of optimum currency areas.
This theory will prove useful in understanding the differences between a fixed exchange
rate system and a currency union, in examining the tradeoffs of joining a currency union,
and in analyzing the case of the euro. The chapter concludes with a historical overview of
how monetary unions in Europe developed.
Introduction
A currency union or monetary union refers to a collection of countries or states that
replace their individual national currencies with a single common currency. This concept
was introduced by Robert Mundell in 1961, when monetary unions were virtually
nonexistent at the national level.
In 1999, a group of 11 countries began using the euro as a currency. These were the
original members of a monetary union known as the Eurozone. As of December 2010,
there were 16 countries using the euro, denoted €. On January 1, 2011, a seventeenth
country was added. The euro became legal tender in Estonia, replacing the Estonian
kroon at the exchange rate of €1 = EEK 15.6466.
The Ins and Outs of the Eurozone The European Union (EU) is an economic, and
often political, union of countries. The EU sought to increase integration across Europe
by establishing the Economic and Monetary Union (EMU), as planned in the Maastricht
Treaty (1992). The EMU included a monetary union headed by the European Central
Bank (ECB).
Today, countries can join the European Economic Union, the Eurozone, both, or
neither. These differences are known as variable geometry. The following is based on
information from 2011:
■ EU membership: 28 countries (EU-28) shown in Figure 21-1.
● Thirteen countries have joined since 2004 (Bulgaria, Czech Republic, Cyprus,
Estonia, Latvia, Lithuania, Hungary, Malta, Poland, Romania, Slovenia,
Slovakia, and, in July 2013, Croatia).
• In 2016, the United Kingdom voted to abandon EU membership but, as of this
writing, remains an official member.
● There are three candidates seeking membership (Iceland, Macedonia, and
Turkey).
■ Who is in and who is out of the monetary union (the Eurozone):
● Ten EU member countries are not part of the Eurozone: Bulgaria, Czech
Republic, Denmark, Latvia, Lithuania, Hungary, Poland, Romania, Sweden,
and the United Kingdom.
1 The Economics of the Euro
Currency unions are still relatively rare, with the Eurozone proving an exception rather
than a rule. These unions have both costs and benefits.
The Theory of Optimum Currency Area
Consider one country, Home, that is considering joining a currency union with another
country (Foreign), or a group of countries.
An optimum currency area (OCA) refers to a monetary union that forms as the
result of optimizing or rational behavior. The countries form the union for their own
Market Integration and Efficiency Benefits Adopting a common currency implies the
countries have a fixed exchange rate (equal to 1). If there is a greater degree of economic
integration between the home region (A) and the other parts of the currency zone (B), a
larger volume of transactions will exist between the two, increasing the economic
benefits associated with lower transactions costs and reduced uncertainty.
Economic Symmetry and Stability Costs Similar to a fixed exchange rate regime, a
common currency implies that each region will lose its monetary autonomy. The
Simple Optimum Currency Area Criteria
The net benefits of joining a currency union equal benefits less costs:
■ Benefit: As market integration rises, the efficiency benefits of a common currency
increase.
■ Cost: As symmetry rises, the stability costs of a common currency decrease.
Figure 21–2 shows the symmetry‒integration diagram with the OCA and FIX lines
What’s the Difference Between a Fix and a Currency Union?
The decision to fix a national currency versus joining a currency union differ, as reflected
by different FIX and OCA lines in Figure 21-2:
■ A country with a fixed exchange rate regime still has options to follow an
intermediate regime or even to float.
● In Europe, the ERM allows for exchange rate bands of ±15%.
● In Denmark, the Danish krone is pegged to the euro at ±2%, but has the option
to allow more depreciation or appreciation.
■ Once a country joins a currency union, it is very costly to exit.
● There are costs associated with printing new currency and redefining contracts
in national currency that are currently defined in common currency.
● Examples of economic crises associated with redefining contracts in new
Other Optimum Currency Area Criteria
In addition to the efficiency gains and stability costs, countries may consider other
factors.
Labor Market Integration Previously, we assumed countries with fixed exchange rate
regimes did not have labor market mobility. If there is labor market mobility, this would
help mitigate the effects of asymmetric shocks in the currency union.
Suppose there is a negative shock to Home.
■ Home output falls and unemployment rises.
■ There is a (relative) excess supply of labor in Home and an excess demand for
labor in Foreign.
■ Labor migrates into Foreign for work, reducing unemployment in Home.
Greater labor market integration reduces the need for autonomous monetary policy
because shocks will have a smaller effect, as labor migrates to where it is most
productive, sharing the benefit or burden of asymmetric shocks.
All else equal, higher labor market mobility reduces the stability costs and increases
the efficiency gains from monetary union. This is shown in Figure 21-3.
Fiscal Transfers In addition to monetary policy and labor market adjustments, fiscal
policy can respond to asymmetric shocks.
■ If a currency union allows fiscal policy to be independent, then the policy can
respond to asymmetric shocks.
Monetary Policy and Nominal Anchoring When deciding to join a currency union, the
Home country must examine the performance of its national central bank relative to the
central bank of the currency union. Joining the currency union will eliminate autonomous
monetary policy.
■ If the Home central bank suffers from inflation bias, then the benefit of joining
the currency union is greater.
■ If the common central bank is politically independent, it can resist popular and
political pressure, reducing potential inflation bias.
● This can help Home establish a more credible and effective nominal anchor.
The benefit of nominal anchoring was important for Eurozone member countries that
have historically experienced high inflation rates, such as Italy, Greece, and Portugal.
All else equal, the OCA line shifts down (Figure 21-3) when:
■ The Home nominal anchor worsens.
■ The currency union nominal anchor improves.
Political Objectives The decision to join a currency union affects not only the economic
welfare but also the political welfare of the country.
Countries may opt to join a currency union for political, security, strategic, or other
non-economic reasons.
■ When the United States expanded west in the nineteenth century, it was assumed
that the new states would adopt the existing common currency. Regions joined
more for political unity and added security than for economic benefit.
■ There is some evidence that Eastern European countries seeking EU/Eurozone
membership have based their decision on the desire for political unity rather than
the OCA criteria discussed previously.
In Figure 21-3, countries between the OCA and OCA2 lines may opt to join the currency
union, even if the economic benefits rest on OCA1. The added political benefits
(represented by OCA2) mean the country will join the currency union.
APPLICATION
Optimum Currency Areas: Europe Versus the United States
In practice, it is difficult to measure the true costs and benefits of currency union. This
application considers an alternative, comparative approach. We consider the following
question: How does Europe compare with the United States on each of the OCA criteria?
The question is premised on the idea that the United States is an optimal currency area.
Goods Market Integration within the EU Measure: Manufacturing exports to other
regions within the United States or the EU. Result: Individual regions within the United
States trade more heavily than EU countries.
Symmetry of Shocks within the EU Measure: Correlation of state or country’s GDP
growth rate relative to the entire region (United States or EU). Result: The EU average
correlation is similar to that of the United States.
■ The United States and the EU have an average correlation of approximately 0.5.
■ Evidence suggests EU countries are subject to neither more nor fewer local
shocks than states in the United States.
Labor Mobility within the EU Measure: Population born in a different state or country
of the United States or the EU. Result: Labor is far less mobile in the EU than in the
United States.
■ More than 30% of U.S. residents were born in a different state within the country.
Only 1.5% of EU residents were born in a different EU country.
■ The same is true of year–to–year flow of labor across states or countries.
Why does the EU have poor labor mobility?
■ Culture and language.
Fiscal Transfers Measure: Changes in state or country tax revenues offset by federal or
regional transfers. Result: The United States has stabilizing fiscal transfers. The EU does
not.
■ For each $1 decline in state government revenue, federal transfers refund 15
cents.
■ In the EU, individual countries attempt to offset in a similar way, but there is no
system–wide fiscal transfer program. The EU budget accounts for only 1% of the
EU GDP and is dedicated to other purposes (agricultural subsidies).
Summary Based on the OCA criteria, the Eurozone falls short of the United States as a
successful optimum currency area. Although the EU countries experience similar shocks,
the region suffers from lower trade volumes, poor labor market mobility, and lack of
fiscal federalism.
Are the OCA Criteria Self–Fulfilling?
In the previous model, we assumed the costs and benefits of a currency union are
exogenous and given. However, some argue that these are actually endogenous, so even
if the OCA criteria are not currently met, forming a currency union will mean they are
met in the future.
Joining a currency union may affect potential efficiency gains and costs:
■ Potential effects on efficiency gains:
● Joining a currency union promotes trade by reducing transactions costs.
● Even if OCA criteria indicate trade volumes are too low ex ante, the act of
joining a union increases the potential efficiency gains.
● The ex ante and ex post outcomes are shown in Figure 21-6 (Points 1 to 2).
● Evidence is mixed and there is no consensus on the magnitude of these
effects.
■ Potential effects on stability costs:
● Countries within a currency union could experience a reduction in stability
costs because of increased goods market integration.
● Countries within a currency union might experience an increase in stability
costs stemming from specialization.
* Economies of scale mean that countries will more heavily specialize
because trade barriers and transactions costs disappear.
* This increases the likelihood that a country will suffer from asymmetric
shocks.
Summary
We have used the theory of optimum currency areas to identify the costs and benefits
associated with joining a currency union. The criteria for joining a currency area are more
strict than the criteria for fixing the exchange rate. Based on empirical evidence, it is
unlikely that the EU is an optimum currency area. We now turn to examining why the
Eurozone exists in a historical context.
H E A D L I N E S
Currency Unions and Trade
Background:
■ Earlier empirical research indicated that the gains associated with a currency
union are as large as a 235% boost in trade (Rose, 2006).
■ These results are surprising because most evidence indicates that reductions in
exchange rate volatility have very small effects on trade volume.
■ These estimates are unreliable because most of the countries used in the studies
were small, poor, and formerly under colonial rule.
■ Today, the euro area provides a broader sample of large economies.
Key issues and statistics:
■ According to Baldwin (2006), the boost to trade within the euro area associated
with the adoption of single currency is estimated at 9%. EU countries outside of
Lessons:
■ Variable geometry in the EU creates a natural experiment for measuring the costs
and benefits of a currency union.
■ The empirical evidence from Baldwin (2006) indicates that the OCA criteria are
not likely to be self–fulfilling.
■ More reforms are needed to fully capture the efficiency gains of a currency union,
especially through improved labor market mobility.
Discussion questions:
■ Suppose you were interested in examining the efficiency gains associated with the
EU (rather than the Eurozone). Refer to the map shown in Figure 21-1. Which
countries would serve as a natural experiment to identify these potential gains and
why?
■ Given Baldwin’s (2006) findings, are OCA criteria self-fulfilling? Are there
limitations with his analysis?
■ This article focuses on the efficiency gains rather than the net benefits
(considering stability costs). Based on the estimates from Baldwin’s study and
2 The History and Politics of the Euro
This section provides a historical context for understanding why the Maastricht Treaty
and ultimately the Eurozone were established in Europe.
A Brief History of Europe
Table 21-1 provides a timeline of European integration from 1870 to 2007. In earlier
chapters, we learned the history of the international monetary system:
Back from the Brink: Marshall Plan to Maastricht, 1945–91
■ The Marshall Plan, 1947 to 1951:
● A plan to rebuild the economic infrastructure of Western Europe after World
■ The Treaty of Rome, 1957:
■ Challenges to the EC:
● How to deal with expansion—deciding whether and when to admit new
members. Member countries wanted to avoid admitting countries with weaker
economies and political ties, but it was expanded to include 12 countries by 1986.
Crises and Opportunities: EMU and Other Projects, 1991–99
■ There was increasing political momentum toward a “single market” in 1992
(Single European Act).
● The end of the Cold War in 1989 left several Eastern European countries,
■ In 1991, the Maastricht Treaty (Treaty on the European Union) established the
EU with the purpose of creating “ever closer union among the peoples of
Europe.”
● Later treaties formalized the Maastricht Treaty blueprint.
■ Challenges to monetary union:
● The ERM crisis in 1992 was caused by speculative attacks on several
The Eurozone Is Launched: 1999 and Beyond
■ The euro launched in 11 countries on January 1, 1999. Those countries’ national
currencies were removed from circulation.
● The European Central Bank (ECB) conducts monetary policy for the
Eurozone.
■ Table 21-2 shows which EU countries are members of the Eurozone, the ERM, or
neither.
● Currently, there are 19 “in” countries.
● Three EU countries are members of the ERM.
■ There are 9 “out” countries: Except for Sweden and the United Kingdom, all are
expected to join the ERM and eventually adopt the euro.
■ All EU countries are expected to work toward joining the Eurozone. Only
Denmark and the United Kingdom can opt out of the euro legally. In practice,
Sweden has opted out, too. And there is a good deal of popular opposition to the
euro in those three countries. When votes have been taken, joining the Eurozone
has nearly always been a losing proposition. It will be some time before the world
sees the end of the British pound, the Danish krone, and the Swedish krona.
Summary
Historically, European countries have been accustomed to fixed exchange rate regimes,
so perhaps the move toward a currency union is not surprising. Integration is still a work
in progress, but the evolution of the EU and Eurozone appears to be driven more by
political factors than economic ones.
3 Eurozone Tensions in Tranquil Times, 1999–2007
Between 1999 and 2007, the Eurozone was considered a success. This was a period of
relative economic stability and growth, with no major recessions and no inflation issues.