Monetary Union
Optimal measurements

Academic discussion of European economic and monetary union has largely been shaped by the theory of optimum currency areas (OCAs), which holds that economies prone to asymmetric real shocks should not form common currency areas. In Discussion Paper No. 915, Research Fellow Peter Bofinger argues that this theory's restrictive assumptions bear little relation to European realities. The use of the exchange rate to adjust relative prices assumes that each country produces only one good, whereas all EU members have diversified production structures, and trade unions' increased freedom from money illusion and willingness to accept nominal wage cuts provide an alternative adjustment mechanism. Flexible exchange rates will not always compensate for shocks, and past real exchange rates reflect factors that monetary union will remove and therefore cannot be used to predict their future pattern. The EMU debate focused on potential savings of transaction and information costs and foreign exchange reserves, but it completely neglected EMU's impact on monetary policies.

Bofinger develops an alternative approach that emphasizes currency areas' performance in terms of policy credibility, their responses to asymmetric monetary shocks and the efficiency of monetary targeting and policy instruments. This indicates that with EMU already in place, France and the other low-inflation EU countries could have benefited substantially from the interest rate reductions achieved in Germany since late 1992. This approach also improves on the theory of OCAs since it explains why nation states outperform their constituent regions or cities as currency areas: the money demand function is necessarily less stable if currency areas are smaller than the jurisdictions within which agents are free to shift assets. Similarly, speculative capital movements generally enhance the volatility of intra-regional flows when separate currency areas form an integrated financial area like the EU, in which minimum reserve instruments are easily circumvented and thus increasingly ineffective. Since money demand is more stable at the European than the national level, so EMU would therefore improve the efficiency of policies based on quantitative monetary targets and monetary policy instruments.

Is Europe an Optimum Currency Area?
Peter Bofinger

Discussion Paper No. 915, February 1994 (IM)