Economists define an optimum currency area as the region where adopting a single currency would result in the maximization of welfare and improved macroeconomic performances (Allen, 2009). This concept explores the criteria, costs and advantages of establishing a common currency region. Furthermore, the OCA model can as well be seen as a structure for finding answers to the question on how to select the prime exchange rate of the government. Due to the symmetrical trait of disturbances and the mobility of factors of production, it seems optimal to abandon the nominal exchange rate and to gain from the decrease in transaction costs related to the use of a single currency. In comparison to the Canada, Europe has a variable real exchange rate (Kundera, 2013).
The acceptance of the Euro by twelve European nations not only carried significant benefits but also established the biggest common currency area in current history. This paper tries to summarize and clarify the most contributions to the OCA theory. The optimum currency area criteria have been revised by many economists (Arnold, 2014). They arrived at a point of deducing four primary standards that must be accomplished so that the regions can merit from the adoption of the common currency. The four criteria included the following. The first criterion is the innovation of automation system of exchange of funds to suffering regions due to asymmetric shocks. The second criterion is that labor markets are incorporated as well as employees can willingly commute within regions. The third is that associates can do business exclusively within their spheres and lastly the monetary progressions in the diverse provinces are in point.
The benefits of creating a common currency area amongst countries removed foreign exchange and dodging transaction cost, and at the same time heightened competition over regional borders (Krugman, 2013). The reduction in transaction cost reduced arbitrage practices thus improving effectiveness. While most of these benefits thrive very well in the market of respective countries, they attract potential setbacks for a nation in a currency union. According to Krugman (2013), one major downside effect is being unable to control local financial policies, which must be submitted to a shared financial authority. Secondly, a country lacks the power to influence through depreciation, for instance, its ratio of conversion (Encinas-Ferrer, 2014). When these two policies lose their grip, they pose a fundamental challenge to the country’s fiscal situations that do not rhyme with those of the latest currency associates, when the economic strategy stands accessible.
Due to this shocking predicament, economists have been forced to create a concept which highlights criteria for optimum currency area. This essay shows how the Euro-zone regions and Canadian regions fulfill the optimal currency area standards. Consequently, primarily it is not termed in this phenomena, a nation like Canada can as well be termed as a fiscal amalgamation (Handler, 2013). The use of a single currency between regions carries a significant benefit such as increase in competition, price comparison and elimination of foreign exchange (Bond, n.d.). As the European republics concluded to bolt from separate currencies to Euro, Canadians shared their dollar in the establishment of the country.
The two regions portray a contrast that determines how effective a particular currency attracts suggestive questions for the forthcoming partisan and monetary guidelines. As a result of incorporation, the Euro-zone nations results in a political amalgamation. Similarly, the nations might mutually use a common currency whereas at the same time functioning as an independent state. The following are the criteria that the Canadian and the Euro- zone countries established to explain the theory of optimum currency area to guarantee a little and firm rise in the standard rate through all members’ nations. Mundell compared the two regions with the following comparisons optimum currency area criteria.
Comparison of EU and Canada as Optimum Currency Areas
Trade: The Premise for a Common Currency
This criterion is one of the major concepts that indicate the level with which the associate provinces trade amongst each other prompting the force for financial incorporation. Countries anticipating to do business with their market partners in other nations should typically carry out a foreign operation conversion to change their local currency into the foreign exchange to purchase and trade significant merchandises (Bond, n.d.). During the exchange, a burdensome barrier might be created and hinder the value of exchanged goods in the associated countries due to hefty tax fines commission (Bond, n.d.).
Price differences also attract inconveniences to practice business in the involved countries (Arnold, 2014). Therefore a shared currency would standardize and improve effectiveness while reducing arbitrage chances by permitting for example contrasts. Consequently, on a transparent trade-jeered approach, the anticipation for a mutual exchange area is crystal perfect. The advantage lies between the two countries that are exclusively trading together when they share a common currency because of the heightened efficiency from the reduced arbitrage prospects as well as the removal of foreign conversion operation cost (Carbaugh, 2009).
As it is a challenge to create a particular inception of the strength of the local trade in providing adequate proof a joint currency, the justification shows that twelve nations that form the Euro-zone are contented with this segment of the optimum currency area standards. The advantage of joint monetary area standards are distinct. For instance, removing transaction cost of the foreign exchange on 65% of the country’s trade market signifies an abrupt decline in one of the hindrances to trade (Pasimeni, 2014). The remaining 35% is still traded with the exchange transaction cost with outsiders; this cost would stand still irrespective of the choices made by Germany regarding the adoption of Euro or the D-mark (Pasimeni, 2014). Due to this, the moment the exchange concept is valued, the Euro-zone nations denote an optimum currency area.
Additionally, the 77.5% of Canada’s global trades encompasses importations from as well as exportations into the U.S government (Pasimeni, 2014). Through this, it can be argued that a common currency between the U.S government and the Canadian’s provinces would contribute a lot to eradicate the hindrances of business operations than only possessing a joint currency in the Canadian regions. If trade existed to be the only issue to reflect on, the Canadian regions would not denote the same common currency level with countries in partners (Bond, n.d.). The trade involving provinces represents a lesser segment of the whole trade than business deal with the Americans, which is involved in the financial merger (Røste, 2008).
Asymmetric Shocks and Common Currency
This criterion as postulated by Mundell is the second concept to explain the technique with which OCA operates. This criterion is concerned with the business cycles of the member economies. For the member countries to experience the benefits of a currency union, the different provinces must undergo a similar economic shock projections as well as being influenced by them evenly (Siedschlag, 2010). For instance, asymmetric shocks happen in this scenario, which indicates that different economies have related alignments. For example rise in the price of national oil as an external force pushes the asymmetric shocks to happen (Wagué, 2012). This applies to the two regions sharing the same OCA, or when one region is undergoing a boom while the other is hindered in stagnation.
A problematic experience arises when two regions join and share a common currency. This is due to the specific provinces that hold no power to control the two significant economic rule mechanisms. Regarding the connecting factor of joint currency, these two regions have no power to control the floating exchange to fit the carrying monetary experiences concerning the provinces, nor even applying a depreciation. For instance, when they try to evade a stagnation. The exchange amalgamation as well guarantees the expense of mechanism that limits across the rates of interest to a joint financial policy (Wagué, 2012). Therefore, a participating nation undergoes a downturn with which it cannot reduce the rates of interest to elevate investment and bring about recovery.
Consequently, there exist a dilemma in the central monetary policy, in a manner that rates of interest should be introduced evenly for all involved provinces using a joint currency Véron (2012), which is a hectic process to conduct the monetary policy effectively. Regions will experience different growth rates, which means that a single province can likely force and introduce a contractionary practice to control the growth of, as the other region, would need an expansionary strategy to remove it from the stagnating phase.
Looking at the Eurozone countries, they have expensed management for the fiscal procedure to the European Central Bank. They are only left with the monetary strategy that guides them about their domestic economies (Willett, Permpoon & Wihlborg, 2010). However, the stability of European growth pact merely disqualifies the efficiency of monetary rule. The Euro-zone recommends that no nation with a GDP less than 3 percent is supposed to run the budget. The second recommendation is that countries should tend to keep their budget in balance. These two recommendations limit the regions with latent rule applications, worsening the impact of the poorly-tuned fiscal course of action when experiencing irregular shock.
Comparing with the Canadian, Willett, Permpoon and Wihlborg (2010) argue that Canadians are predominantly exposed to irregular shocks. The recorded varying in development highlights the provincial view of Canadian monetary market, which still and already depends on the natural wealth of the country. Véron and Guntram (2013) states that this unequal distribution of resources leads a country to have varying economic cycles among provinces. Similarly, volatility of the global commodity prices further exposes regions to asymmetric shocks. In comparison, the Canadian regions undergo larger irregular shocks compared to Euro-zone nations. The economy of these nations are hugely influenced by the cost-added production and services.
The presence of asymmetric shocks for these both regions Canada and European stipulates that both regions do not denote any optimum currency areas. Although, none of the geographical distanced regions of the world is probably going to possess faultlessly matching markets. However, a variety of techniques has been set to eradicate and control the impacts of asymmetric shocks (Pasimeni, 2014). Especially mitigation measures notably focus on a joint labor economy concerning provinces and monetary transmissions towards provinces undergoing the irregular shock.
The Need for a Common Labor Market
The common currency area is strongly linked with the free movement of goods between regions which act as a precursor of better monetary economic markets in these regions. This scenario of free movements of goods creates an environment that withstands a lasting feasibility (Carbaugh, 2009). A joint labor economy is important for providing alleviation techniques of irregular shocks between the provinces. In a situation whereby one region is experiencing a boom while the other a recession, labor can shifts from stagnating phase to the prospering phase. Consequently, employees must be willing to move freely within the regions.
Another benefit is that a common labor market can help to eradicate the impact of irregular shocks over adjustment earnings. If incomes in a stagnating countries drop, this makes rates within regions to go down as well (Arnold, 2014). The fall of prices is a boost to depressed countries since it increases the demand of their products. On the other hand, prospering nations experience loss of demand in the miserable province because of their huge rates (Encinas-Ferrer, 2014). The unlucky authenticity is that Eurozone does not hold a joint labor economy. Rules of substantial state mostly differ both in size and opportunity and control of the elasticity of the labor economy.
The image in Canada is a bit optimistic. Employees are willing to transfer between regions within situations of an extended provincial recession; however, they are distanced by bigger geographical locations.
Stability through Transfers
This is the fourth criteria of the optimum currency area that focuses on the automatic transfers of members to regions suffering from asymmetric shocks. As a result of poorly managed fiscal policy in the provincial phase, movements from increasing provinces to low-performing provinces signifies additional crucial technique to curb the impacts of irregular shocks. These movements could create finances for long-drawn-out monetary policy to remove a region in the recession phase (Arnold, 2014).
Spontaneous transmission methods do not occur in the European regions, but the equalization program runs in the Canadian regions in order for the workers to represent one particular category of movement’s system that would thrive effectively in the European regions. The programs work with the provinces undergoing the economic conditions and are more advantaged than the ordinary nation at large. They pay into the finances that are later reallocated suitably to the provinces lagging behind.
The main focus of equalization program to regions of depressed provinces with extra money is to propel their businesses by sharing the resources from well-developed and richer regions. The setback of the program is that merely twofold provinces including Alberta and Ontario, were considered sponsors of the initiative (Bond, n.d.). The provinces experience dissatisfaction since they are taxed for their accomplishments (Bond, n.d.). Although, there are natural materials, the origin of asymmetric shocks we experience are distributed at the extent of the province. As a result, Alberto won over the oil deposits because he termed it as a game of geographical roulette (Bond, n.d.).
Whereas the equalization concept is structured in changes in GDP per individual concerning regions, a subsequent spontaneous transfer procedure concerning the income tax scheme as well exist in Canada. This program is centered on the variances in GDP development across regions that doubtfully mark it to be more essential in withstanding an optimum currency area because it openly talks about the irregular shocks across provinces (Kundera, 2013).
The future progress recommendations of Euro-zone is crystal clear that it has to increase its long-term viability. Similarly, it had to bring significant reforms both in labor market and fiscal transfer to start representing an optimum currency area (Kundera, 2013). The existing unstable stabilization techniques concerning both segments severely underestimates Euro-zone’s capability to conform to asymmetric shocks amongst provinces, an issue that is widely sophisticated by the limitations levied on monetary policy by the EU’s growth and stability pact. On the other hand, regarding the future of regions in Canadian as a currency area, it is complete (Willett, Permpoon & Wihlborg, 2010). The likelihood of an ultimate fiscal amalgamation with the Americans, whereas possibly applied on business-centered platforms, stands a subject of distinct argument as well of the optimum currency area standards might have been assessed over new amalgamation.
This paper has captured certain concepts that are crucial towards giving evidence for the theory of Optimum Currency area (OCA). Over the past decades after the Mundell 1961, the seminal paper has greatly advanced, a lot of additional literature have been incorporated into this theory and at the same time serving as an essential element in establishing the European monetary union. Similarly, irrespective of the growth of the OCA concept, the contributing OCA concepts discussed above are very important. Consequently, no exact and simple method would be potentially decided openly whether a nation must or would not participate in a common currency area. Most frequently, radical dynamics are those leading the decisions concerned with entering into a common currency area.
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