Optimum Currency Area Essay

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Optimum Currency Area
Which factors are important for the success of a monetary union (Common Currency Area)?
The main costs associated with a common currency are that member countries are likely to suffer from asymmetric shocks. Suppose a country gets hit by a shock that increases unemployment only in that country, they have no control over monetary policy to boost the economy and no control over devaluing the currency to gain competitiveness as the exchange rate is fixed.
For a currency union to have the best chances of success, is must prevent asymmetric shocks. However failing that, there should be a set of factors that allows countries to adjust to asymmetric shocks. These factors are considered important for the success of a monetary union and are:
1.
Wage Flexibility
.
Since wages are the most important component of costs (and thus prices), an adjustment in the real exchange rate can come about through wage adjustments.
.
Flexibility in wages are thus desirable for a common currency area (CCA)
.
Theoretically suggesting that the currency areas should be quite small as large zones will have mobile labour markets
2.
Labour Mobility
.
Labour mobility can also provide the necessary flexibility, with workers moving from one country (with high unemployment) to other countries with more favourable demand conditions in order to reduce unemployment issues
.
Theoretically suggesting that the currency areas should be quite small as large zones will have mobile labour markets
3.
Fiscal Transfers
.
Another mechanism to deal with asymmetric shocks is a system of automatic fiscal transfers.
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In the above example, countries with momentarily higher tax revenues would transfer funds into the country with high unemployment, e.g. as unemployment benefits, to mitigate the adverse effects
.
These fiscal transfers should be more or less automatic so that each country gets help in a bad macro state, implying that currency unions need to be large as they will be more diversified to provide such transfers
4.
Trade Openness
.
In very open economies, the exchange rate as a policy
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