Essay on "Economics Optimal Currency Area"

Essay 7 pages (2259 words) Sources: 10 Style: Harvard

[EXCERPT] . . . .

Economics

Optimal Currency Area

An Optimal Currency Area (OCA) is a geographic area that is best suited to share the same currency because it would optimize the region's economic efficiency. It sets up a description for what distinct qualities it would take for an area to become an OCA and either merge currencies or have a new currency. The OCA theory is used to determine if an area is capable of becoming a monetary union.

National sovereignty is an important consideration when a region is determining whether or not to create an independent currency. The economics of independent currencies with fixed instead of flexible exchange rates is a debate of longstanding.

An autonomous currency and monetary policy are potentially useful tools to stabilize economies, especially when other stabilization instruments are not present or unsatisfactory.

The support for optimal currency area theory and the pointers for which circumstances make a country or region suited for independent monetary policy were originally from the Keynesian tradition for the industrialized countries of the middle of the twentieth century (Goldberg, 1999).

Usually, the OCA system presents a group of circumstances by which a region or country has the greatest opportunity of benefiting from owning an autonomous currency with an adjustable exchange rate. Exchange rates are used to adjust the comparative price of two countries' goods either for output stabilization or for loosening domestic macroeconomic policies from a balance of payments constraint.

Relative prices and demand for a region's workers and goods can be adjusted by the movements in exchange rates and are most useful when specific OCA reference criteria are satisfied.

These criteria include: asymmetric shock among countries; the inability of cross-border labor flows to contribute substantially to the smoothing of employment cycles; and the absence of other fiscal-based methods for achieving output or balance-of-payments stabilization in response to shocks (Goldberg, 1999).

For the exchange rate to be a successful stabilization tool, the elasticity of the supply has to be there during the "premature" stages of any economic transition.

The foreign and domestic elasticity of the demand for goods are not yet determined and employment will not rapidly adjust. In these circumstances, the normal optimal stabilization policy criteria may not be relevant, when applied to output/balance of payments targets, for the transition economy to decide whether to begin or maintain an autonomous currency. So it doesn't really matter whether economies in transition satisfy the criteria that indicate optimum conditions be present for introducing independent currencies.

The traditional optimum currency area criteria, interpreted in terms of optimal real stabilization policy, are only useful if the exchange rate is able to effectively perform the task of short-term stabilization (output or balance-of-payments) to which it is assigned (Goldberg, 1999).

Using a common currency within a region or country is not necessarily a plus. It is true a common currency does increase the functionality and credibility of the money. And, as we have mentioned, a country might improve its stability by cooperating with a larger monetary union because of the expansion of trade and increased capital flow. On the other hand, a country that associates with a monetary union gives up financial autonomy and loses its ability to respond to those asymmetric shocks we mentioned. The country also loses seigniorage (the process of creating money to be held by others) and the capability to act as a lender of last resort should there be any banking crisis.

OCA focuses on four interrelationships between the countries that might impinge on the benefits of adopting a common currency: the extent of trade, nature of disturbances, degree of labor mobility, and fiscal transfers. If the potential union members heavily trade among each other, a monetary union would benefit from the reduction of transaction costs. Second, if the countries experience similar shocks, the cost of giving up monetary policy independence would decrease. Third, high labor mobility across borders can be a use mechanism for adjustment to asymmetric shocks that lead to high unemployment in a subset of the union membership. Fourth, if region-specific shocks prevail, a federal fiscal system would provide regional insurance (in the form of federally funded unemployment insurance benefits), thereby attenuating the impact of regional shocks on interregional income differentials.

Pros and Cons of a Monetary Union

One of the main positives regarding a joint monetary union with a common currency would be its impact on efficiency and decreased transaction costs. Also, it eliminates the cost of converting currency in order for the individual from the countries involved, to trade. Any savings in all of this are also increased by reductions in the costs of accounting, invoicing and other support operations.

The future efficiency of decision-making is impacted positively because a common currency does away with uncertainties about values of exchange rates in the future, unlike floating rates and pegged-rate systems. There is also an argument that interest rates come down with the removal of exchange rate risk. The effect this has is to cut national debt servicing, and reduce the difficulty and complexity of across-the-border price comparisons.

It would be significant to note the importance of exchange rates being truly fixed. In other words, the periodic adjustment of exchange rate pegs cannot and do not eliminate all the costs and uncertainties accompanying variable rates. The "hard" pegs of currency boards cause some observers to lean toward them rather than the "soft" fixity of adjustable pegs.

Price stability is another point in the positive list of fixed rates. This applies especially to inflation-prone countries. These countries can sort of "import" price stability by pegging to a low-inflation country or joining low-inflation currency unions. This could be a strong consideration for countries in Latin American and probably would explain why Argentina and Ecuador might go after currency board or dollarization schemes.

Another potential significant positive is the benefit from being united with other countries through their economies and currencies. Perhaps, by forming a monetary union, human rights issues, environmental policies, social policies and industrial policies could be discussed within the member countries to overcome the problems of credibility. It is even possible that forums, discussions, or a treaty could further strengthen relationships and the cooperation within the union.

Under consideration off and on throughout the years is the idea of a single world currency union. As it fits into our pros and cons discussion, it is fitting to take a look at it. Could the Euro, or dollar, or Pound Sterling become the future world currency? And what would be the advantages and disadvantages of that move.

The Pound Sterling, U.S. dollar or the Euro could all be replaced by the currency they may be pegged to. So, the world of currencies may be a bit smaller than we think which makes the idea of a world currency more realistic than might seems possible right now.

Almost 65% of global central bank reserves are U.S. dollars. About 25% are in euros. This makes the dollar, and within some reason, the euro, representative of world currencies. About 60% of financial transactions around the world are accomplished in U.S. dollars, thus making it the global exchange currency. But the resurgence of the euro since the late 1990s is giving the dollar rough competition. Since early 2007 the value of euro notes in circulation is over €600 billion. It is now the currency with the highest value in cash circulating in the world.

There have been a lot of variants of world currency proposed. The eurodollar -- a composite ero and dollar; the "Terra," digital gold currency backed by gold, and many others. The creation of any currency would need the financial backing of a supreme Central Bank.

A Belgian economist -- Bernard Lietaer -- proposed the Terra as a world currency, based on a group of 12 commodities including gold, grain, meat, wine, cotton wool, copper, electricity and a half hour of labor! It would be free from inflation.

Back to the advantages and disadvantages of this single world currency which are basically the same pros and cons for any monetary union (Gimp, 2008).

A single world currency could bring with it substantial benefits such as:

Elimination of transaction costs related to trading currencies

Do away with the need of maintaining forex (foreign exchange) reserves

Do away with currency risk, benefiting foreign investors

Eliminate the chance of currency failure, which would make foreign investment decisions much easier in emerging economies (Gimp, 2008)

Such a currency would, in one go, eliminate the problem of current account deficits as there would be no need for foreign exchange.

While, the benefits seem immense, such a currency could virtually do away with the need for forex trading. But, forex traders can relax for now as the adoption of such a currency is not a likelihood in the near future due to the vast variations in global political and economic structures. Some of the key reasons that go against a single currency include (Gimp, 2008):

Loss of national monetary policy -- A single currency would imply a single… READ MORE

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