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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
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:
1. The Economics of the Euro
a. The Theory of Optimum Currency Area
i. Market Integration and Efficiency Benefits
ii. Economic Symmetry and Stability Costs
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
e. Application: Optimum Currency Areas: Europe Versus the United States
i. Goods Market Integration
ii. Symmetry of Shocks
iii. Labor Mobility
iv. Fiscal Transfers
v. Summary
f. Are the OCA Criteria Self-Fulfilling?
2. The History and Politics of the Euro
a. A Brief History of Europe
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
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?
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.
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
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
● 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.
(2008), Slovakia (2009),Estonia (2011) and Croatia (2013). The remaining 10
are still out of the Eurozone.
● Many of the “outs” want to join the monetary union.
● Countries seeking Eurozone membership must peg their currencies to the euro
as part of the Exchange Rate Mechanism (ERM) for at least two years. As of
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
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.
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
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.
■ If the currency union is founded on fiscal federalism, then there is a unionwide
political structure that permits interstate transfers.
union. This is illustrated by Figure 21-3.
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.
● Policy makers within Home may be unable to resist the temptation to boost
● This can help Home establish a more credible and effective nominal anchor.
The benefit of nominal anchoring was important for Eurozone member countries that
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
■ There is some evidence that Eastern European countries seeking EU/Eurozone
membership have based their decision on the desire for political unity rather than
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
Goods Market Integration within the EU Measure: Manufacturing exports to other
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.
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.
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.
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
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:
■ 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
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
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
■ These results are surprising because most evidence indicates that reductions in
■ These estimates are unreliable because most of the countries used in the studies
■ 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
the Eurozone experienced a 7% increase in exports during the same period.
■ Empirical strategy: Compare EU countries that have remained outside of the
Eurozone with those that are in.
■ According to Baldwin (2006), a one-time boost in trade did not come from
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
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
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:
■ 1870 to 1914: Gold standard system of fixed exchange rates
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
War II. The United States supplied much of the financing.
● Important because the funds were allocated by a European High Authority
● Six countries in Western Europe established the European Economic
● The EEC later merged with other organizations in 1967 to form the European
Community (EC), broadening the scope beyond economic coordination.
■ Challenges to the EC:
● How to deal with expansion—deciding whether and when to admit new
● The collapse of Bretton Woods raised the issue of monetary policy
coordination.
* The EC established the European Monetary System (EMS) in 1979, with
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,
formerly dominated by Soviet rule, anxious to establish ties with the
● The EU subsequently enlarged, reaching 27 EU countries in 2007.
■ 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
European currencies, forcing most off of the ERM. The origins lay in
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.
● National central banks retain some responsibilities, including representing
● 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,
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
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.
