1 Today’s Agenda  Critique of the traditional OCA theory  New OCA theories -Endogeneity vs. specialization  Putting it all together…

2 Critique of the Traditional OCA Theory  OCA theory lists several criteria for an OCA -Problem of inconclusiveness (How many do you have to fulfill? To what extent?) -Problem of inconsistency (Not all criteria can be matched at the same time!) E.g. small countries are usually very open, but at the same time not very diversified  Traditional OCA theory takes asymmetry of shocks as given – do they have to be?  How efficient are monetary policy and exchange rates in stabilizing an economy?

3 ”Lucas Critique”  What is it?  Implication for OCA theory:

4 Endogeneity Theory of Frankel and Rose

5 Specialization vs. Endogeneity  Read pp from F.P. Mongelli’s article ”’New views on the Optimum Currency Area Theory: What is EMU telling us?”  What is the main difference between the theories? In groups discuss arguments favoring endogeneity and those favoring specialization. Which theory do you think is right? How could you find out?

6 More Endogeneities:  Financial integration -Investments across borders -Direct foreign investment, mergers, acquisitions  Labor market institutions -Economic integration can make labor markets more flexible -Increased labor mobility?

7 Combining Costs and Benefits  Countries are more willing to enter a currency union if  Large benefits -The more EMU members trade with each other the bigger the benefits OR  Small costs -Synchronous business cycles -Efficient adjustment mechanisms (other than monetary policy)

8 Joint Analysis of Costs & Benefits ”OCA” line Openness (~high benefits) Income correlation (~low costs) EMU? Benefits > Cost Costs > Benefits EU27?

9 Endogeneities and Specialization Once More ”OCA” line Openness (~high benefits) Income correlation (~low costs) EMU ? ? Other endogeneities move the OCA line

10 To sum it all up: EMUMore trade Asymmetric income changes Similar income changes Nat’l fiscal policy? Federation? Similar income changes Asymmetric shocks intra- industry Asymmetric income changes Symmetric shocks specialization (Assuming labor immobility and wage inflexibility) risk sharing no risk sharing Similar institutions Differing institutions Nat’l fiscal policy? Federation? OK NO

11 To sum it all up: Comments  If EMU leads to labor market or financial market institutions becoming similar, or to increased risk sharing (e.g. cross-border investments), probability of success increases -Indicated as thicker arrows in diagram  Also, if EMU leads to higher labor mobility, success should be more probable

12 Lesson of Today: There could still be hope for the EMU!

13 Pre-Lecture Assignment  Is the EMU an OCA? -Compare the current EMU against the ideas presented in the OCA theories -What about EU28? -Search the Internet for sources -Notice, that you may not be able to give a definite answer…