1. Optimal Currency Area Theory
The Case of Sweden and the EMU
Ithurbide: Prévision des taux d’échange
Györgyi Kacsandi, Signe Svensson, Stefan Zeugner, 2002

2. Overview Question Theory Case Application: Sweden
DISPOSITION
Overview
Question
Theory
What is an asymmetric shock?
OCA Criteria
Case Application: Sweden
Statistic Study
Conclusion
Academic Results

3. Is the EMU an Optimum Currency Area for Sweden?
QUESTION
Is the EMU an Optimum Currency Area for Sweden?

4. Time line 1995 Sweden joins the EU
QUESTION
Time line
1995 Sweden joins the EU
1996 The Swedish Government launches «Wait and See» Policy considering EMU
1999/2002 The EMU is put into reality by the introduction of the Euro in the 12 member states
2002 Swedish prime minister says that the smooth introduction of the euro advances the date of a possible referendum to not later than 2005, and most likely 2003.

5. Why Sweden adopted « Wait and See » policy in 1996:
QUESTION
Why Sweden adopted « Wait and See » policy in 1996:
Financial Situation of the State
The Rate of Unemployment
Not Sufficient Debate; Legitimacy
Other EU-countries

6. Definition An Optimum Currency Area is an area
THEORY
Definition
An Optimum Currency Area is an area
neither so small and open that it would be better off pegging its currency to a neighbor,
nor so large that it would be better off splitting into sub-regions with different currencies.

7. What is an asymmetric shock?
THEORY
What is an asymmetric shock?

8. Assumptions:
Price levels stick to their initial level
Initial current account is balanced
Asymmetric shock:
Productivity increase in Airbus production
THEORY
Camembert Supply q p q p
Airbus Demand PC
Airbus Supply
Camembert Demand PA
Excess supply for Airbus
Excess demand for Camembert

9. I. Flexible Exchange Rates
THEORY
I. Flexible Exchange Rates
France is devided into two currency areas: in the Northeast the NE-Franc and in the Southwest the SW-Franc:
In the booming Northeast, interest rates rise – whereas in the staggering Southeast they fall. The NE-Franc appreciates versus the SW-Franc and the justified prices are quickly reached on « international » markets.
But there is no inflation in the NE and no monetary-caused unemployment in the SW.
Moreover, each region can fine-tune its monetary policy to its particular shock.

10. II. Fixed Exchange Rates:
THEORY
II. Fixed Exchange Rates:
Labor mobility
In order to decrease the excess supply of Airbuses, workers will « quit » their jobs in the Southwes, move to the Northeast and will become Camembert producers.
Camembert supply will increase (shift to the right), Airbus supply will decrease (shift to the left)
Þ The price movements are by far not as excessive as in case I.

11. THEORY
Camembert Demand q p
Camembert Supply q p
Airbus Demand PC
Airbus Supply PA

12. III. Fixed Exchange Rates:
THEORY
III. Fixed Exchange Rates:
Adjustment of Prices
Labor productivity has increased Þ one needs less work hours to build an Airbus (relative to work hours for making Camembert) Þ The price of an Airbus in terms of Camemberts falls Þ the producers (workers) of Airbuses receive less Camemberts in total (real wage)
i.e. incomes in the Southwest deteriorate, while the Northeast is experiencing a boom. This implies falling wages (along with the prices) in the Southwest – or unemployment. The Northeast will suffer from inflation.

13. THEORY
Camembert Supply q p PC q p
Airbus Demand PC
Airbus Supply
Camembert Demand PA PA

14. Why should France have a common currency?
THEORY
Why should France have a common currency?
Decision rule: Common currency if the advantages > disadvantages in the long run
Advantages
Reduce transaction costs and exchange rate risk
Provide a nominal anchor for nominal policy
Disadvantages
No independent monetary policy
i.e. if France forms an Optimal Currency Area!

15. Fixed Exchange Rates – Common Currency
THEORY
Fixed Exchange Rates – Common Currency
Reducing the risk of assymetric shocks:
Symmetric disturbances Þ business cycle correlation
High trade integration leads to higher income correlation
Product diversification in the region
Dampening the effects of assymetric shocks:
Labor mobility
Price flexibilty Þ wage flexibilty
High trade integration (because of the marginal propensity to consume)
Fiscal federalism

16. The Case of EMU and Sweden
CASE APPLICATION
The Case of EMU and Sweden
Labor mobility:
Currently 1.9% of labor force in EU countries comes from another EU member state. In the U.S., 1,5% of population are moving inter-state every year!
Fiscal Federalism:
If a U.S. state suffers an income shock, it will be compensated for 40% of the loss by fiscal federalism (less taxes, more subsidies). The EU budget is limited to 1.27% of EU-GDP.

17. Fixed Exchange Rates – Common Currency
CASE APPLICATION
Fixed Exchange Rates – Common Currency
Reducing the risk of assymetric shocks:
Symmetric disturbances -> business cycle correlation
High trade integration leads to higher income correlation
Sectoral diversification in the region
Dampening the effects of assymetric shocks:
Labor mobility
Price flexibilty -> wage flexibilty
High trade integration (because of the marginal propensity to consume)
Fiscal federalism

18. Four main criteria for OCA of Sweden and EMU
CASE APPLICATION
Four main criteria for OCA of Sweden and EMU
Sectoral diversification
Correlation of income cycles
High trade integration
Similarity in price and wage patterns

19. Statistic results

20. CASE APPLICATION
Statistic results
Source: OECD STAN.

21. CASE APPLICATION
Statistic results
Source: OECD National Accounts.

22. CASE APPLICATION
Statistic results
Source: OECD National Accounts.

23. CASE APPLICATION
Statistic results

24. CASE APPLICATION
Statistic results

25. CONCLUSION
Our conclusion
The criteria are not sufficiently fulfilled to make the EMU an Optimum Currency Area for Sweden
However, the development shows that the EMU might be so in the future
If Sweden chooses to join for political reasons,
Þ Sweden might suffer asymmetric shocks due to the little correlation to the other EMU countries
Þ Sweden should try to achieve increased price and wage flexibility to damp the socio-economic costs of OCA

26. Academic results (Rose, 2001)
Assumptions
Trade patterns and income correlations are endogenous – what happens in the long run?
How?
Econometric research on trade streams
Result?
Participating in a common currency area has a large positive impact on trade, which can be quantified.

27. Prognosis? Statistic results
ACADEMIC RESULTS
Statistic results
(Rose, 2001) cont.
Prognosis?
If Sweden joins the EMU for political reasons, it will be more likely to fulfill the OCA Criterions in the future
Entering the EMU would also
Þ increase Swedish trade with the EU by %
Þ increase Swedish GDP by about 11 %