The document discusses the history and development of the eurozone. It began in 1999 when 11 European nations formed a currency area called the Eurozone to use the euro as their shared currency. There are now 19 member countries that use the euro. The document examines whether the eurozone meets the criteria to be an optimal currency area and finds it falls short compared to the United States. Specifically, economic integration and labor mobility between eurozone members is weaker than between U.S. states. While economic shocks may be similarly symmetric, fiscal transfers are negligible in Europe. The document also discusses some political motivations for forming the eurozone despite the economic costs.

1. Eco 328
The euro

2. In 1999, 11 nations in Europe
elected to form a “currency
area”, known as the Euro area,
or Eurozone.
There are19 member countries.
They all use the new notes and
coins bearing the name euro
and the symbol €.
2
Giampieroortenzi/Thinkstock
The euro

3. • The European Union (EU) is a mainly economic, but
increasingly political, union of countries that is in the process
of extending across the geographical boundaries of Europe.
• The main impetus for the euro project came in 1992 with the
signing of the Treaty on European Union, at Maastricht, in the
Netherlands.
• Under the Maastricht Treaty, the EU initiated a grand project
of Economic and Monetary Union (EMU).
• A major goal of EMU was the establishment of a currency
union in the EU whose monetary affairs would be managed
cooperatively by members through a new European Central
Bank (ECB).
3
The Ins and Outs of the Eurozone

4. Different countries choose to participate in different aspects of
economic and monetary integration
As of 2014, the EU comprised 28 countries (EU-28).
• A country can be in the EU but not in the Eurozone.
• Those who wish to get “in” must first peg their exchange rates
to the euro in a system known as the Exchange Rate
Mechanism (ERM).
4
The Ins and Outs of the Eurozone

5. An optimal currency area
5
• In 1961 the economist Robert Mundell wrote a paper
discussing the idea of a currency area, also known as a
currency union or monetary union, in which nations replace
their national monies with a common currency.
• He thought it purely a theoretical exercise, as such a union
would never be politically feasible.
• Half a century later most of Europe uses the same currency.
• Mundell received the Nobel Prize the same year the euro
launched.

6. EU à la Carte This map
shows the state of
Europe as of 2014,
indicating which
countries are in the
European Union (EU),
which EU members are
in the Eurozone or the
Exchange Rate
Mechanism (ERM),
and future members.
Notes:
EU-Eurozone (18): Austria,
Belgium, Cyprus, Estonia,
Finland, France, Germany,
Greece, Ireland, Italy, Latvia,
Luxembourg, Malta, Netherlands,
Portugal, Slovakia, Slovenia,
Spain
EU-ERM (2): Denmark,
Lithuania.
EU-Other (8): Bulgaria, Croatia,
Czech Republic, Hungary, Poland,
Romania, Sweden, United
Kingdom.
Candidates (5): Iceland,
Macedonia, Montenegro, Serbia,
Turkey.
6

7. Market Integration and Efficiency Benefits
If there is a greater degree of economic integration between the home
region (A) and the other parts of the common currency zone (B), the
volume of transactions between the two and the economic benefits of
adopting a common currency due to lowered transaction costs and
reduced uncertainty will both be larger.
Economic Symmetry and Stability Costs
If a home country and its potential currency union partners are more
economically similar or “symmetric” (they face more symmetric shocks
and fewer asymmetric shocks), then it is less costly for the home
country to join the currency union.
When two regions adopt a common currency, each region will lose its monetary
autonomy, and the monetary authorities who have control of the common currency
will decide on a common monetary policy and set a common interest rate for all
members.
The Theory of Optimum Currency Areas
7

8. Cost and benefit
• As market integration rises, the efficiency benefits of a common
currency increase.
• As symmetry rises, the stability costs of a common currency
decrease.
If the net benefits are negative, the home country would stay out
based on its economic interests. If the net benefits turn positive,
the home country would join based on its economic interests.
Simple Optimum Currency Area Criteria
8

9. • When countries consider forming a currency union, the
economic tests (based on symmetry and integration) set a
higher bar than for judging whether it is optimal to fix.
• Denmark is in the ERM, so the krone is pegged to the euro,
but not in the Eurozone.
• Denmark appears to have ceded monetary autonomy to the
ECB, but transactions between Denmark and the Eurozone
still require a change of currency.
• Denmark has the option to exercise monetary autonomy or
leave the ERM at some future date if they want the flexibility
of a more freely floating exchange rate.
9
What’s the Difference Between a Fix and a Currency
Union?

10. 10
The greater the symmetry of shocks and the higher the degree of economic integration, the
greater the case for pegging the exchange rate. Higher degrees of symmetry and
integration, still, may justify even greater monetary commitment, such as a currency union.

11. • Italy is one of several countries in which rumors of departure
from the Eurozone have surfaced from time to time.
• An Italian exit from the euro would be difficult and costly.
Reintroducing new lira as money would be difficult and all
Italian contracts in euros would be affected by the
“lirification” of the euro.
• Other countries that have tried these kinds of strategies, such
as “pesification” in Argentina and de-dollarization in Liberia,
have resulted in economic crises.
• Exit from a peg is easy, but exit from a common currency is
much more difficult.
11
What’s the Difference Between a Fix and a Currency
Union?

12. Other Optimum Currency Area Criteria
Labor Market Integration
• In the event of an asymmetric shock, labor market integration
provides an alternative adjustment mechanism through
migration.
Fiscal Transfers
• A third adjustment channel is available if fiscal policy is not
independent but built on top of a federal political structure
with fiscal mechanisms that permit interstate transfers—
known as fiscal federalism.
• If Home suffers a negative shock, fiscal transfers from Foreign
allow more expansionary fiscal policy in Home.
12

13. Several other criteria can make a currency union more attractive, even for given levels of market
integration. Factors that lower costs or raise benefits will shift the OCA line down and to the left,
expanding the OCA zone.
13

14. We can use comparative analysis to see if Europe performs as well
as or better than the United States on each of the OCA criteria,
which would lend indirect support to the economic logic of the
euro.
Goods Market Integration As intra-EU trade flows rise further,
the EU’s internal market will become more integrated, but on this
test Europe is probably behind the United States.
14
Optimum Currency Areas: Europe Versus the United States

15. OCA Criteria for
the Eurozone
and the United
States
Most economists
believe that the
United States is
much more
likely to satisfy
the OCA criteria
than the EU is.
Why?
Data in panel (a)
show that
interregional
trade in the
United States
rises to levels
much higher
than those seen
among EU
countries.
15

16. We can use comparative analysis to see if Europe performs as well
as or better than the United States on each of the OCA criteria,
which would lend indirect support to the economic logic of the
euro.
Symmetry of Shocks Most EU countries compare quite
favorably with the U.S. states on this test. There is no strong
consensus that EU countries are more exposed to local shocks
than the regions of the United States.
16
Optimum Currency Areas: Europe Versus the United States

17. Data in panel (b)
show that U.S.
and EU shocks
are comparably
symmetric.
17

18. Labor Mobility
• Labor in Europe is much less mobile between states than it is in
the United States. The flow of people between regions is also
larger in the United States than in the EU.
• Labor markets in Europe are less flexible, and differences in
unemployment across EU regions tend to be larger and more
persistent than across the United States.
• The labor market adjustment mechanism is weaker in Europe.
On this test, Europe is far behind the United States.
18
Optimum Currency Areas: Europe Versus the United States

19. Data in panel (c) show
that U.S. labor markets
are very integrated
compared with those of
the EU.
19

20. Fiscal Transfers
• Stabilizing transfers, whereby substantial taxing and spending
authority are given to the central authority, exist in the United
States but not in the EU.
© 2014 Worth Publishers
International Economics, 3e | Feenstra/Taylor
20
Optimum Currency Areas: Europe Versus the United States

21. Data in panel (d)
show that interstate
fiscal stabilizers are
large in the United
States, but
essentially
nonexistent in the
EZ.
21

22. • On the OCA criteria, the EU falls short of the United States as a
successful optimum currency area.
• Goods market integration is weaker, fiscal transfers are
negligible, and labor mobility is low. At best, economic shocks
in the EU are fairly symmetric, but this gives only limited
support for a currency union given the other shortcomings.
• On balance, economists tend to believe that the EU, and the
current Eurozone within it, were not an optimum currency area
in the 1990s and that nothing much has happened yet to alter
that judgment.
22
The eurozone is not an OCA

23. The US seems to fit all the characteristics for an OCA, but not the eurozone
23

24. Monetary Policy and Nominal Anchoring
• If Home suffers from chronic high inflation that results from
an inflation bias of Home policy, the more politically
independent common central bank of the currency union could
resist political pressures to use expansionary monetary policy
for short-term gains.
• Italy, Greece, and Portugal are Eurozone members that
historically have been subject to high inflation.
• High-inflation countries are more likely to want to join the
currency union, the larger are the monetary policy gains of this
sort.
24
Other Optimum Currency Area Criteria

25. Political Objectives
• Forming a currency union has value for political, security,
strategic, or other reasons.
• Political benefits can be represented by the OCA line shifting.
• In this scenario, for countries between OCA1 and OCA2, there
are economic costs to forming a currency union, but these are
outweighed by the political benefits.
25
Other Optimum Currency Area Criteria

26. • With the devastation of World War II, many feared that dire economic
conditions would undermine the legitimacy of European capitalism, with
the neighboring Soviet bloc all too eager to spread its alternative
Communist model.
• The Marshall Plan, from 1947 to 1951 poured billions of dollars of aid
into Western Europe to help rebuild the economic infrastructure.
• A series of ever tighter binding treaties ensued in the following decades
which brought Europe closer together and saw many more countries
come into the fold. The EU now has 28 member states (many ex-
Soviet), 19 of which are in the Eurozone.
• Even if it did not make perfect economic sense, proponents still
reasoned along two lines
• An OCA could be self-fulfilling. Sign the treaties and print the
money, and the member states will become integrated.
• The political considerations outweigh the economic costs.
26
Politics of the euro