Optimal Currency Area (OCA)
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- Some of the criteria for being an optimal currency area are (Mongelli, Francesco, 2002). “New Views on the Optimum Currency Area Theory: What is EMU telling us?” ECB Working Paper No. 138.):
- Meaning: workers and capital can move freely across the region.
- Price and wage flexibility across the region.
- Meaning: price and wages can change quickly in response to economic fluctuations.
- Ability of the government to transfer funds or adjust taxation across the region.
- The main point of an OCA is how well a region or country can handle asymmetric shocks without its own exchange rate.
- Example – shocks when a country has its own exchange rate.
- If a group of countries is truly an OCA, internal and external balance can be maintained in the face of asymmetric shocks.
- If a group of countries is not an OCA, internal balance is not obtained across the monetary union in the face of asymmetric shocks.
- If a group of countries is not an OCA, union-wide monetary policy cannot address each country’s needs – leading to greater reliance on fiscal policy. A country with a negative asymmetric shock often ends up with budget deficits and political pressure to remove oneself from the union.
- How do the countries of the EU compare to the states of the US in terms of the OCA criteria?
- Labor mobility: US > EMU
- Capital mobility: US ~ EMU
- Price flexibility: US ~ EMU
- Wage flexibility: US > EMU
- Union level fiscal transfers: US > EMU
- Why do EU countries not meet the criteria as well as the states of the US?
- Language and cultural barriers make it harder for a worker to move from one European country to another
- Labor mobility is limited.
- Wages in Europe are not determined as much by the market as they are by labor unions and wage bargaining agreements with the government.
- Wages are less responsive to economic fluctuations, making it harder to induce labor movement.
- Each country in the EMU maintains individual control over tax collection and government spending; there is no EMU level fiscal authority. Contrast this to the US where the Federal Government has an enormous budget and taxes and spends at a national level.
- The EMU cannot transfer funds or adjust taxes from one region to another.