Optimal Currency Areas Essay

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Szevak Nzsdejan

Fourth Essay for International Economics

“In 2008, Spain and the US state of Florida experienced a similar bursting of a housing bubble and subsequent drop in aggregate demand, but Spain is in a worse position to deal with this. For, whilst neither Spain nor Florida can independently devalue their currencies, the US labour market is much more geographically integrated than the European Union’s.” Explain this statement and explain what other factors you would wish to consider before deciding whether membership of the Euro was on balance beneficial to Spain. I. Introduction
Both Spain and Florida are so-called ‘regions’ in a common currency area; the Eurozone and the United States of America, respectively. The case for a common currency depends on the whether these regions constitute an optimal currency area. The key feature of such an area is internal factor mobility and external factor immobility. The first condition is where Spain and Florida differ the most; the degree of internal factor mobility in the US is considerably higher; both labour and capital can move smoothly in contrast with the Eurozone. The main frictions presenting internal factor immobility in the Eurozone are cultural differences, language and shallow economic integration in comparison with the US. These frictions particularly effect the movement of labour, whose income accounts for two thirds of GNP in the EU 1. Common currency areas are typically less stable to shocks than those with flexible exchange rates. This is due to the lack of a variable exchange rate to absorb economic shocks by correcting for change in an area’s relative competitiveness. The lack of labour market mobility, political and economic integration in the Eurozone suggests that it may not be an optimal currency area, in which case the disadvantages of having a common currency outweigh the advantages. This leads us to question whether it was beneficial for Spain to join the Euro and why Spain is worse off than Florida.

II. The Effects of an Aggregate Demand Shock to a Common Currency Area
The effect of a negative aggregate demand shock, such as the bursting of a housing bubble experienced by the two different regions, can be illustrated using a simple DD curve framework 2. On the vertical axis, e is the exchange rate; Y is income. Yn is the natural level of income and e0 is the fixed common exchange rate.

1

This is an estimate, which has been obtained from “International Economics: Theory & Policy”, Krugman, Obstfeld & Melitz, p. 578.
2

For simplicity and clarity, there is no reason to include a full AA-DD model as due to the common currency, the AA curve is fixed/irrelevant and a single region cannot operate its own separate monetary policy. 1

Szevak Nzsdejan

Fourth Essay for International Economics

e DD0

e DD1 DD0

e0

E0

e0

E1

E0

Yn
Figure 1.

Y

Y1

Yn
Figure 2.

Y

e DD1 DD2 DD0

e0

E1

E2

E0

Y1

Y2

Yn

Y

Figure 3.

At the natural level of income, there is full employment in the economy – or unemployment is at the natural level. Figure 1. represents the system in its equilibrium state before the aggregate demand shock, with DD0 being the original aggregate demand curve and E0 the initial equilibrium point. The burst of a housing bubble shifts aggregate demand to DD1. This shift is accompanied by a decrease in income, which in a fixed exchange rate case would have implications for the demand of money. However since the supply of money is not in the control of the region, i.e. Spain, there will just be a simple outflow of resources and goods from the country, and national income will decrease to Y1. This will result in an increase in unemployment. The aim is to get back to the natural level of income and thus return the economy to full employment.
2

Szevak Nzsdejan

Fourth Essay for International Economics

If the region operated a flexible exchange rate regime than it…