Abstract

The purpose of this paper is to determine if the Euro zone is an optimal currency area. It involves inspecting existing related literature and data for certain prerequisites set out by the Optimum Currency Area theory. The outcome is that the Euro zone is not an optimal currency area, despite major improvements seen following the introduction of the Euro in the areas including …. etc . Meanwhile, the prerequisites of ….. etc are not met.

Introduction

In 1979, the European Commission established the European Monetary System (EMS) arrangement, involving a large number of countries who were part of the European Economic Community (EEC) fixing their exchange rates based on a unity known as the European Currency Unit (ECU). Following this event, discussions over the possibility of the Euro zone being an Optimal Currency Area emerged. In January 1999, the European Union introduced the Euro as it’s common currency, the Euro. Initially, the euro served its purpose as an electronic currency utilised by banks. In January 2002, the Euro was introduced as banknotes and utilised as a legal tender for all transactions in 12 countries including Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

The rest of the dissertation is structured in the following format.

Section II includes a description of the theory of Optimum Currency Area which was the workings of Robert Mundell in the early 1960s. In Section III covers related literature on the subject as well as empirical

Related Literature

This section includes a review of the related literature on the Optimum Currency Area theory.

Mundell (1961) published his work on the theory of optimum currency areas, which focused geographical regions that was that would benefit from a single monetary policy under a common currency or definitely pegged exchange rates. This was to counter Friedman (1953)’s argument that strictly flexible exchange rates enabled corrective changes required to bring about external equilibrium.

In order to determine whether a geographical region was an optimal currency area, Mundell (1961) studied the mobility of factors, in particular labour, as the main perquisite. In an currency which has the characteristics of high mobility of labour and other factors products, there is a high probability that the need for altering the real factor prices is likely to be lower. High Labour mobility implies that workers have the flexibility of moving to different counties, which have more desirable demand conditions in order to reduce unemployment in their home country. Meanwhile, wage flexibility implies that an adjustment in the real exchange rate in the event of asymmetric shock can come about from wage adjustments as wages are the most important component of costs, therefore prices.

Later on, several other factors were taken into consideration. McKinnon (1963) argued that the more a country is in involved in international trade, the benefits it is likely to experience, here depreciation would have lesser effect in rebalancing a country’s external deficit. Kenen (1969) debated that a well diversified economy was a criteria of optimum currency area perquisites. In this case, the economy can adjust relatively well by absorbing sector-specific shocks thought shifting production within the internal economy. Meanwhile, Fleming (1971) believed that similarity of inflation rates should be a one of the perquisites to determine an OCA region as this will help maintain balanced current -accounts in other counters in the monetary union.