Explain what an optimal currency area is - Would the UK membership of the single currency enhance the chances of the EU becoming an optimal currency?
Explain what an optimal currency area is. Would the UK membership of the single currency enhance the chances of the EU becoming an optimal currency?
A currency area is an area made up of several states, which use a fixed exchange rate system between them. This area can be achieved in one of to ways. The first is by keeping the countries current currency and the national central bank but ensuring that their monetary policies stay consistent with the area and keep the currency exchange rates the same. The second is by giving up the national currency and all states combining to form a single currency, with its own independent central bank.
To get an optimal currency area, the currency area must have certain factors; these are immune demand shocks to all of the states’ economies, little or no labour market differences, similar growth rates and similar cultural experiences. All of these must occur if a state is to become a member of such an area. It will only be optimum if the individual states wreak benefits from membership within the currency area. In this essay I will use what was the European monetary system now the European Single currency to explain each of these, which will in turn answer the second part of this question.
Optimal currency areas came about in Robert Mundell’s study of demand shocks, He wrote “A theory of Optimum currency areas” in the American Economic Review 1961. As the demand shocks are the main cost of an optimal currency area. This is due to the individual state’s loss of control of its monetary policy to control localised and temporary demand shocks, i.e. asymmetric (affects only one of the states). If the states can not cope with these shocks they would have to take effective action for their own economies which if they have loss of control of their monetary policies they would not be able to do, and if they do have control, would this mean they would be able to stay within the regulations of the currency area. An asymmetric shock could be devastating to an economy, which can not control its own monetary policy. We can use Robert Mundell’s example to show this, If there are two countries which share a common monetary policy i.e. are in a currency area, and export a particular good for example oil. If the price of oil rises in country A, there will be less of demand for its production in that country thus a shirt inwards of its demand curve to D2. This will raise unemployment due to the lack of work in production. However in country B, its demand curve will shift outwards causing prices and employment to rise. To combat the inflation in B the central banks would want to put interest rates up to stop the spending (reducing the money supply). However this would make country A’s unemployment worse. And it therefore the reverse of what country A would need to do.
