1. The document discusses the costs and benefits of forming an Optimum Currency Area (OCA). Key costs include the inability to use exchange rate adjustment and specialization leading to asymmetric shocks. Benefits include reduced transaction costs and increased price stability. 2. To mitigate costs, the document suggests implementing a single fiscal policy and better financial integration across members. It also recommends monitoring members' balance of payments and issuing import directives from the central union to maintain positive balances. 3. Forming a successful OCA requires addressing issues like asymmetric shocks, demand adjustments, and balancing members' economic structures through policy coordination.

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The Cost and Benefit Analysis of an Optimum Currency Area
MSc Banking and International Finance (2013-2014)
Toulouse Business School
Author- Akash Baruah
Research Guide – J.F Verdie

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Abbreviations:
OCA – Optimum Currency Area
BOP- Balance of Payment
Introduction:
A Currency area is said to be optimal when they satisfy the basic
conditions of price stability, full employment and a positive BOP balance,
if this is not such a case, then the currency regime is not said to be
optimal. There also has to be symmetry in shocks and flourishing trade
within the union (positive BOP with the OCA). An Optimum Currency Area
can only be formed when the very economic structure of the countries in
consideration of forming the Union are same. This is important for better
integrated intra-industry trade, smoother labour movement and for the
symmetry of shocks to be felt across the states in time of a crisis. `There
should be significant amount of trade among the proposed countries, for
them to reap the benefits of an Optimum Currency Area. (Kenen 1969)
argues that the better diversified an economy is, the least it is bothered
about asymmetric shocks and exchange rate regimes. Thus diversification
of an economy can be considered an important point before forming an
OCA. Even there should be trade diversification within the OCA and
greater amount of trade should be within the domain of the OCA.
Adjustment cost in the Balance of Payment should be reduced and the
transformation process from one business cycle to another should be
much faster.
A trade off between inflation
and unemployment, both are utterly unacceptable for the welfare of the
population within the OCA, which is the primary reason for forming it.
Thus there has to be a mechanism to reduce the adverse effects of
shocks on both the phenomenon and to speed up the recovery process
more than which otherwise would have been possible without an OCA. In
this dissertation of mine, I have tried to highlight and discuss some of the
issues involved in forming a Monetary Union and how to make that union
an Optimum Currency Area. While addressing these issues, I have
explained the fundamental causes and also provided some probable
solutions to the problem. There are many costs and benefits in forming a
Monetary Union and the integration of nations should be mainly to reap
the benefits out of it.

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Contents:
1. Cost
1.1 No exchange rate devaluation 4
1.2 Asymmetry of shocks 5
1.3 Specialization 6
1.4 No demand adjustment by Inflation 6 - 7
2. Benefits
2.1 Reduction in transaction cost 7
2.2 Greater price stability 7 - 8
2.3 Labour mobility 8 - 9
3. Suggestions
3.1 Single Fiscal Policy 9 - 10
3.2 Balance of payment monitoring and Import directives by the Central
Union 11
4. References 12

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1. Cost
1.1 No exchange rate devaluation
If there is an increase in the money supply in the home country within a
monetary union due to the fiscal policy, which leads to an increase in
demand for goods, should lead to an increase in prices to maintain
equilibrium or increase the supply side measure to maintain the
demand. If the supply side measure cannot be adequately restored,
there would be massive disequilibrium in the economy as the prices of
goods cannot be raised to absorb the excess demand in one of the
member states, If the demand in the whole of the union is stable. In this
situation the aggrieved member state will have to import goods in order
to maintain demand and in the process run up huge current account
deficits. Thus the aggrieved state should devalue its currency to restore
competitiveness and increase its exports, but it cannot do so in a
Currency Union. It suffers a lot in the process of restoring its economic
condition with such constraints. The situation forces the aggrieved
state into huge current account deficit and results in Governments
taking austerity measures to reduce demand and even massive
unemployment. The Phillips curve provides us with great insight in this
regard. Therefore there has to be harmony between the fiscal and the
monetary policy, which is very hard to achieve in a Monetary Union.
Due to this the rate of transformation of the aggrieved economy to
restore its competitiveness is a very painful task and comes with a lot
of price.
If the real
income increases with the rise in money supply due to fiscal policy, as
the inflation is fixed, this will result in the increase in demand for money.
Thus to reduce the demand of money and goods there has to be a hike
in the interest rates. To restore the Balance of payment position also,
the interest rates should be raised to increase the capital inflow in the
capital account. But due to the Monetary Union, interest rates cannot
be hiked in order to reduce the deficit and increase the inflation.
The situation
becomes even more adverse when the foreign price level falls further in
comparison to the home currency. This makes it even more difficult for
the member state to increase its exports, as it cannot devalue its

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currency, neither can it raise interest rates and the mounting current
account deficit pushes the state into deep recession.
1.2 Asymmetry of shocks
The assumption of sharing shocks across the member states in times of a
crisis is proven to the contrary (Greece, Spain, and Portugal) and even the
free movement of labour, as there is high degree of unemployment in many
European countries, which is the only legitimate Monetary Union in the world
at the present situation. (Fernando 2004) Financial integration can be
achieved when all the market participants have the same set of rules in terms
of the financial instruments, when all the participants are treated equally and
when all the participants have equal access to the financial instruments.
Unification of the financial market should provide an insurance against the
asymmetry of shocks felt, which is not at all true and is well proven by the
aftermath effects of the Lehman crisis. Different investor behaviour in different
countries is a strong reason for this. This requires an even more specific
financial integration. Thus the assumption of the reduction of cost of a
monetary union through this is utterly unfulfilled. Financial integration is very
important to be achieved along with banking unification for a monetary union
to become an Optimum Currency Area. Otherwise there will be massive
unemployment and economic recession.
Non integration of the
financial market and different credit allocation policies by different countries
and also specialisation of countries, can lead to massive asymmetry in the
shock absorption across the OCA. Different credit allocation policies adopted
by banks can lead to causing bubbles in certain sectors and hence make
countries prone to specific financial crisis.
An asymmetry of shock in a
member country can cause huge deficit and crisis in that country. If the
government to reduce deficit levies more tax on the companies, there will be
either reduction of wages or massive unemployment in order to maintain the
competitiveness of the single market.
Due to the creation of an
OCA and a single market, all the member countries will be very highly
positively correlated with financial crisis and if there is no proper financial
integration, a single financial crisis will result in massive asymmetry in shocks

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and the aggrieved countries will find it very difficult to come out of the crisis by
staying inside the OCA.
1.3 Specialisation
(Kalemli-Ozcan, Sorensen, Yosha-2003) Economic integration leads to better
risk sharing opportunities and hence increases the incentive for specialisation
which in turn affect the symmetry of macroeconomic fluctuations, in turn
makes the shocks more asymmetric. Economies of scale, plays a part in it.
(The case of Germany can be highlighted with its specialisation in the
Automobiles Industry). Therefore increase in the specialisation is a benefit for
the OCA and the increase in asymmetry of shocks is a cost for the OCA, there
has to be a systematic trade off between these two.
As the member states should converge
more towards similar kind of economies and engage in similar activities,
reduction in trade barriers provide incentives for the member states to
specialise. This in turn makes the economies to polarise and cause significant
discrepancies during financial crisis and cause a lot of hindrance during
labour mobility.
(Fidrmuc 2004) intra-industry trade gives
rise to symmetry of shocks and more correlation of income and output, where
as inter-industry trade results in more specialization and increases the cost of
a monetary union. Therefore more focus should be given in developing the
member states in such a way that intra- industry trade flourishes and similar
kind of industries develop. Increased trade integration eventually may lead to
decrease business cycle synchronisation as the economies more try to
converge towards specialisation and thus increases the chance of an
asymmetry of shocks felt on the event of a financial crisis.
1.4 No demand adjustment by Inflation
In case of an increase in demand due to a fiscal policy, the excess demand
cannot be absorbed by creating inflation through monetary money supply. In a
Currency Union the banking system will be centralised and inflation cannot be
allowed to rise for the demand adjustment in just one member state. When a
member state is in such a situation, it only has the option of unemployment,

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which takes away the prosperity of its people. The growth rate of an economy
declines as the companies reduce production, income falls and leads to
massive unemployment. This is a very significant cost of a Currency Union
which makes the adjustment cost of an aggrieved state very high.
2. Benefits
2.1 Reduction in transaction cost
Forming a Monetary Union reduces currency transaction costs
considerably, provided the proposed countries within the monetary union
has considerable amount of trade within them. Not all the costs of a
foreign currency cost could be saved by the use of a single currency.
Some foreign currency loans are taken for hedging purposes and some
are taken in the order to reduce the cost of borrowing. Only the cost
associated with the risk of hedging or opportunity cost can be saved from
the use of single currency.
Some costs associated with
foreign trade are huge amount of rents extracted by Banks, Intermediaries
and currency dealers. They are able to earn huge amount of money
through economies of scale, which they achieve due to the large scale
transactions that they handle. large scale currency conversions involve a
bid ask spread, which in relations to trade between countries amounts to
huge costs which could be saved by a monetary union.
2.2 Greater price stability
Due to the creation of a single currency there will be greater inflow of FDI
and capital inflows, both from within the Monetary union and also from the
rest of the world as generally there will be a sense of lower volatility and
stability on the new currency as well as the external purchasing power of
the new currency will also increase. This will lead to the formation of an

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overall optimism towards the OCA. Due to a common rate of inflation
achieved in an OCA, the spread across government bonds within the
OCA reduces to a great extend and result in lower volatility and
strengthening of stability.
With greater price stability, the cost of
uncertainty is also reduced. Thus trade and investment flourishes when
there is certainty and confidence in the environment. This leads to overall
development and growth of the Monetary Union and provides a platform
for the people to move towards prosperity.
2.3 Labour Mobility
Due to the convergence of inflation rate across the OCA, there will be
stability in prices. Due to a very competitive product and price market and
due to longer contracts of labour employment, there will be stability in the
labour market wages. Thus if a crisis occurs within the Currency Area or
in any member state, labour can now move freely from one state to
another. This is also largely possible due to the economic and financial
integration within the OCA and the similar economic structure that they
posses.
Even if the labour is mobile within an
optimum currency area, the movement of labour from the affected country
to an unaffected country is not always possible and besides if more and
more labour moves out, there would be labour scarcity in the home
country, thus giving rise to high labour cost and reduction in firm
productivity. The percentage of imported goods in the living index is a
thing of concern, the more an economy is able to produce goods
indigenously, the less will be the impact of devaluation and labour
adjustment will be smooth. The structure of an economy again affects
directly to the mobility of labour. For a smooth transition of labour the very
structure of the economies should be the same.
Thus in a fixed exchange rate regime
when foreign price level falls, there will be higher demand for foreign
goods, fall in prices and unemployment. The foreign exchange reserves
will fall and the home currency needs to be depreciated. But in a Monetary
Union the transition phase can be much smoother with very low rate of

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unemployment, as labours can easily move from one place to another
within a union. The burden of adjustment in such a case is not only to be
borne by the labour unemployment. But the only precondition for this is
that, economic structures of the countries within the union, has to be
similar.
3. Solutions
3.1 Single Fiscal policy
All the problems of demand caused by the increase in money supply due
to domestic fiscal policy, asymmetry of shocks and speedy recovery from
crisis can all be achieved from a single fiscal policy, which should be
formed for the whole of the union.
If due to a sudden crisis, labour
starts to move from the aggrieved country to a new member state, than
again there would be surge in the prices of the labour market and hence
the cost of production of factories would rise. This would create a
manufacturing and production bottleneck and hinder the growth of the
aggrieved member state. Too much of labour movement is anti-growth. A
particular fiscal policy is very necessary for the whole of the Union and
other fiscal policies of the member states have to be in alignment with the
central fiscal policy.
The after effects of a financial crisis
will always bring about depression and slow economic growth and
unemployment and this will also be the case within an OCA, but our
efforts should be to make the transformation much faster, faster than
within a normal flexible exchange rate area. This requires a single fiscal
policy within the area and more cooperation amongst the member states
to adjust the demand of the aggrieved state and also its BOP position.
Financial Integration should increase and structural reforms should be
taken to reach optimality.
Increasing
the money supply in the aggrieved region can also possibly be a way to

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reduce the demand shock and causing a bit of inflation in that region. If
the overall inflation cannot be increased for a few countries, than there
has to be a single policy and better financial integration to spread the
shocks across the regions.
In an OCA there should be
similar kind of activities, same financial integration and same growth
possibilities and should be governed with a single fiscal policy if possible.
Banking harmony is of utmost important. Credit allocation should also be
taken care of. Specialisation is very dangerous for an OCA and therefore
the single fiscal policy should always aim at balanced development.
If the demand is over powering the
equilibrium in an economy, then the supply side constraints can be
removed by providing subsidies to the companies to carry on with their
production and in turn help create more jobs. Now again this cannot be
undertaken by the same aggrieved economy government, but has to be
done through a single fiscal policy, which is done by a Central
Government of the monetary Union. A federal structure of Government is
very necessary in a Single Currency Area to become an OCA.
When starting of an OCA, even if
there are discrepancies in the economic structure of the different member
states, the single fiscal policy should try to highlight these problems and
make the policy incline towards making these discrepancies disappear
and approach towards attaining a more balanced production and
economic structure. This would later help in smoothing the asymmetry of
shocks, smoother mobility of labour and help attain the goal of an OCA.
The independent countries would take their own specialisation and own
internal lacking into account, which needs to be improved and make fiscal
policies according to their specifications. But the wholesome development
of the Currency Area, with balanced development and more convergence
towards similar economic integration has to be done by a Single fiscal
policy adopted by the Central Government of the Union.

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3.2 Balance of Payment Monitoring and
Import Directive by the Central Union
The BOP Position of a country with the rest of the OCA should
always remain positive, for the very survival of the fundamentals of an
OCA. Openness of an economy and economic integration should always
bring about a positive BOP so as to get the benefits of an OCA. The cost
of isolating itself from the rest of the world should be very well be
compensated by a positive BOP with the rest of OCA. It can surely be
highly surplus, but has to maintain a minimum surplus. The Global BOP
position can be negative and in such a case, it should be helped to
recover by the other member states, by importing from the aggrieved
country and reducing the deficit.
If there is a BOP crisis for a country
due to the increase in imports and more precisely a current account deficit,
it can’t devaluate the currency to increase its exports. But the adjustment
has to be done by raising taxes. It can’t even raise taxes on people due to
political constrain and thus have to raise corporate tax, which in return
results in decrease in the supply side measure, adding to the supply side
constrain. The situation becomes more and more complicated if it is
borrowing within the member states and it can’t increase exports to
outside member states by reducing the value of its currency. There should
be directive given by the Central Commission to other member states, to
import certain goods from the aggrieved member state and not from
others. There might be a scenario that a country is very heavy on import
side, but the monetary union as a whole is having a surplus in BOP, that
might cause a severe constrain on the home country to recover. On the
contrary if a country is having a huge amount of surplus in its BOP and
thus the country will be in a very favourable situation and will grow
stronger if the inflation and price level does not go up. Thus there has to
be complete harmony within the member states to give ample and equal
opportunity to all.

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4. References:
Laurence .S. Copeland, 2005, “Exchange Rates and International
Finance”, Fourth Edition, Essex, Pearson Education limited, 500,
0273-683063
Ferrando, A, Baele, L, Hordahl, P, Krylova, E, Monnet, C, 2004,
“Measuring financial integration in the euro area”, ECB
occasional paper no. 14, April.
Fidrmuc Jarko, 2004, “The endogeneity of the optimum currency
area criteria and intra-industry trade implications for EMU
enlargement” in Paul De Grauwe and Jaques Melitz (Eds)
Monetary Unions after EMU, MIT Press, Forthcoming.
Frederic .S. Mishkin, 2004, “The economics of Money, Banking
and Financial Markets”, Seventh Edition, United States of America,
Pearson, 679, “The Adission Wesley series in economics”, 0-0321-
12235-6.
Kalemli Ozcan, Sebnem, Bent.E. Sorensen, Oved Yosha, 2003,
“Risk sharing and industrial specialisation: Regional and
international evidence”, American Economic Review June 2003
93(3).
Kenen, Peter, “The theory of Optimum Currency Areas: An
Eclectic view” in Mundel and Swoboda (Eds) Monetary Problems
in the international economy, University of Chicago Press, 1969.

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