Chapter 21 (10)
Optimum Currency Areas
and the Euro
◼ Chapter Organization
How the European Single Currency Evolved
What Has Driven European Monetary Cooperation?
The European Monetary System, 1979–1998
The Theory of Optimum Currency Areas
Economic Integration and the Benefits of a Fixed Exchange Rate Area: The GG Schedule
Economic Integration and the Costs of a Fixed Exchange Rate Area: The LL Schedule
The Decision to Join a Currency Area: Putting the GG and LL Schedules Together
What Is an Optimum Currency Area?
Other Important Considerations
Case Study: Is Europe an Optimum Currency Area?
134 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Chapter Overview
The establishment of a common European currency and the debate over its possible benefits and costs was
one of the key economic topics of the 1990s. Students should be familiar with the euro but probably not
with its technical aspects or its history. This chapter provides them with the historical and institutional
background needed to understand this issue. It also introduces the idea of an optimum currency area and
presents an analytical framework for understanding this concept.
The first attempt at a post-Bretton Woods fixed exchange rate system in Europe was the “Snake.” This
effort was limited in its membership and placed too high a burden of adjustment on countries with weak
currencies. The European Monetary System (EMS), established in 1979, was more successful. The
original member countries of the EMS included Germany, France, Italy, Belgium, Denmark, Luxembourg,
the Netherlands, and Ireland. In later years, the roll of membership grew to include Spain, Great Britain,
and Portugal. The EMS fixed exchange rates around a central parity. Most currencies were allowed to
fluctuate above or below their central rate by 2.5 percent, although the original band for the Italian lira and
the bands for the Spanish peseta and the Portuguese escudo allowed for fluctuations of 6 percent in either
direction from the central parity.
After attacks and realignments in its early years, the EMS grew to become sturdier than its predecessors. The
presence of small bands instead of pure fixed rates helped, as did the guarantee of credit from strong to
weak currency countries. The EMS was, in some sense, simply a peg to the DM. Many felt that the
dominant position of the DM had allowed other countries to import Germany’s inflation fighting
credibility and that this was another advantage of fixed rates in Europe.
Chapter 21 (10) Optimum Currency Areas and the Euro 135
euro into a weak currency. Eleven nations participated in the launch of the euro in 1999, with the United
Kingdom and Denmark choosing not to join, Sweden failing the exchange rate stability criteria, and
Greece failing all criteria (Greece joined two years later). The nations in the euro area have ceded
monetary control to the Eurosystem, comprised of the European Central Bank (ECB) plus the 18 (at
press!) national central banks of the euro area. The national central banks are now part of an overarching
structure headed by the governing council of the ECB. The ECB is a very independent central bank with
no political control and little accountability. In addition, a new exchange rate mechanism has begun in
which non-euro EU members peg to the euro.
An illuminating way to frame the question is to compare the United States to Europe. The evidence that
Europe is an optimum currency area is much weaker than the evidence supporting the notion that the
United States is an optimum currency area. Trade among regions in the United States is much higher than
trade among European countries. Labor is much more mobile within the United States than within Europe.
This is significant as capital mobility has increased, suggesting that a country hit with a negative economic
shock may actually experience worse unemployment given that capital will flow to other countries, while
labor does not. Furthermore, federal transfers and changes in federal tax payments provide a much bigger
cushion to region-specific shocks in the United States than do analogous EC revenues and expenditures,
which have no clear mechanism for fiscal federalism. Finally, there are greater differences in factor
endowments in Europe, which may promote greater regional specialization to take advantage of
economies of scale. Such regional specialization increases the possibility of asymmetric shocks that a
common monetary policy has difficulty dealing with.
136 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
A swift bailout by the strong currency EMU members could have resolved the crisis, but countries like
Germany did not want to pay the bill for excessive government spending by other nations. A combined
◼ Answers to Textbook Problems
1. The stability of the EMS depended upon the ability of member countries’ central banks to defend their
currencies. The level of foreign currency reserves to which a central bank has access affects its ability
2. The maximum change in the lira/DM exchange rate was 4.5 percent (if, for example, the lira starts out
at the top of its band and then moves to the bottom of its band). If there was no risk of realignment,
the maximum difference between a one-year DM and a one-year lira deposit would have reflected the
3. A 3 percent difference on the annual rate of a five-year bond implied a difference over five years
of 1.035 = 1.159 (that is 15.9 percent). This means that the predicted change in the lira/DM exchange
4. The answers to the previous two questions are based upon the relationship between interest rates and
exchange rates implied by interest parity because this condition links the returns on assets
5. A favorable shift in demand for a country’s goods appreciates that country’s real exchange rate.
A favorable shift in the world demand for non-Norwegian EMU exports appreciates the euro (and
Chapter 21 (10) Optimum Currency Areas and the Euro 137
6. Compare two countries that are identical except that one has larger and more frequent unexpected
shifts in its money-demand function. In the DD–AA diagrams for each country, the one with the more
unstable money demand has larger and more frequent shifts in its AA schedule resulting in bigger shifts
7. a. While in the ERM, British monetary authorities were obliged to maintain nominal interest rates
at a level commensurate with keeping the pound in the currency band. If this obligation were
removed, British monetary authorities could run an expansionary policy to stimulate the
economy. This would cause the pound to depreciate vis-à-vis the DM and other currencies.
8. Each central bank would have benefited from issuing currency because it would have gained seigniorage
revenues when it printed money; that is, it could have traded money for goods and services. Money
9. A single labor market would facilitate the response of member countries to country-specific shocks.
Suppose there is a fall in the demand for French goods that results in higher unemployment in France.
If French workers could easily migrate to other countries where opportunities for employment were
138 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
10. The United Kingdom had a stronger economy for much of the time frame between 1999 and 2003.
The United Kingdom averaged a real GDP growth rate of 3.4 percent over this period compared to
2.1 percent across the euro zone. Unemployment rates in the United Kingdom were consistently
lower at 5.2 percent over this period compared to 9.0 percent across the euro zone. At the same time,
short-term money market rates were 2.5 percent to 0.5 percent higher in the United Kingdom, and
inflation rates were fairly close to those in the euro zone. Had the United Kingdom been part of the
euro area, it would have shared monetary policy with the other countries. On the one hand, this would
2003.
11. When the euro appreciated against China’s currency in 2007, EU countries that compete with China
in third country export markets should have seen a larger drop in aggregate demand as various customers
may have switched to the suddenly relatively cheaper Chinese products. Germany should be hurt less
than Greece given the assumptions in the question. If Greece had its own currency, it may have allowed
its currency to depreciate against Germany slightly so that it had a smaller appreciation against China.
This may have mitigated the effects on its exporters.
12. Much like the concern that individual country governments would borrow too much and put pressure
on the ECB to print too much money, an excessive CA deficit of an individual country may signal
13. All of these countries experienced significant increases in their current account balances (though the
increase in Italy has been more modest than the other nations.) This is not surprising, as each of these
14. If a country had an “escape clause” and could readily leave the Eurozone, the currency stability
offered by a monetary union is weakened. If the ECB signals that it will no longer act as a lender of
Chapter 21 (10) Optimum Currency Areas and the Euro 139
15. A condition of the bailout package to Cyprus was that some bank deposits in Cypriot banks would
essentially be taxed to help pay for the financial support. To make this tax binding, the government
had to impose a restriction on capital leaving the country or else depositors in Cypriot banks would