The Theory of Optimum currency area and whether or not Europe is an optimum currency area
An optimal currency area is a relatively large geographical area where the adoption of a single official currency for the entire region is preferable to having multiple official currencies due to the benefits that accrue from the use of the former (Carbaugh 282). The United States is an excellent example of an optimal currency area because, despite consisting of 51 fully functional as well as virtually economically independent states, the “area” uses only one official currency; the US dollar.
On the contrary, the Economic and Monetary Union (EMU) in Europe still has a long way to go if it were to become an optimal currency area. The theory of an optimal currency area stipulates that for an economic area to be able to form an optimal currency area, the constituent economic units or countries must be affected by macroeconomic factors’ fluctuation to a largely equal extend. Also, the countries, in the case of economic and/monetary integration must be willing to sacrifice their independent control of two policy instruments: interest rates and monetary policy (Carbaugh 283).
Regarding the two, EMU still needs to work harder to achieve these objectives since, as demonstrated by the recent economic crises in Greece, Iceland, Ireland, Portugal, and Spain, it is made up of a mixture of both economically strong and economically weak members. Thus, these economies are affected to a wide and varying degree by macroeconomic factors’ changes, such as interest rate fluctuations.
Also, EMU has not set up a single, fully operational monetary policy control body yet. Critical members, like Britain, remain largely adamant about ceding their monetary as well as fiscal control powers to “foreigners”. For this reason, they still maintain the use of their national currencies, in the process ending up frustrating the core objectives of creating a European EMU.
Moreover, the structure of labor flexibility in Europe provides a significantly huge challenge for the realization of an optimal currency area because it is such that labor mobility is very low (Carbaugh 284)
If the current U.S. interest rates are 3 percent more than the rates in the European Union
Would the dollar appreciate or depreciate against the euro and by how much?
Higher interest rates in the United States than in the European Union would cause US dollar assets to have a higher yield than Euro assets. Therefore, European investors, because all investors seek to invest in markets with the highest return on investment, would be attracted to buying US securities as well as bank accounts. This would in turn cause the demand for the US dollar to increase and thus make the dollar to appreciate relative to the euro.
I expect the dollar to appreciate by 3 percent per annum since this is the differential interest-earning which exists between dollar assets and euro assets, and which should be eliminated for there to exist “one price” for financial assets between the US and Europe.
If it is different from your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow?
Given that the forward and spot rates are the same, I would expect financial capital to flow from Europe to the US in the short run since investors would rush to buy dollar assets to make profits when the dollar appreciates against the euro shortly. However, before committing their funds to buy US financial assets, European investors would consider the path that the exchange rate of the dollar will take shortly, usually 3 months (Carbaugh 401). Because the dollar is expected to increase in value relative to the euro, capital will flow from Europe to the US as investors would be keen on making exchange gains shortly by selling the dollar asset they would be holding for more euros.
The concept of Purchasing Power Parity (PPP)
PPP is a simple theory that holds that, when the purchasing power (PP) of two currencies is the same in each of their home countries, the nominal exchange rate is in equilibrium (Carbaugh 405). In other words, for one unit of a currency of one country to have the same power of purchase in a foreign market, the nominal exchange rate between the two currencies should be equal to the ratio of aggregate price levels between the two countries under consideration.
The Law of One Price is the basis upon which PPP is founded (Carbaugh 403). For example, a particular farm tool that costs 500 euros in the UK should cost 750 US Dollars (USD) in the U.S when the rate of exchange between US currency and the European currency is 1.5 USD/E. If the farm tool was going at 700 USD, farmers in Europe would prefer importing the farm tool from the US. If this “arbitrage” takes a large scale form, European farmers would push up the demand for the USD as they will need to purchase US dollars before they can buy the cheaper farm tool from the US. Consequently, the US dollar will appreciate against the Euro, thus making the farm tool more costly in the US until a point is reached when the tool will have the same price in the two countries.
Two versions of PPP have been developed by economists: relative and absolute PPP. Absolute PPP holds that when one unit of a domestic currency has exactly equal PP in both the home and foreign market, then there is said to have occurred parity in PP of the currency between the two countries. On its part, relative purchasing power parity holds that the rate at which a currency appreciates is equal to the inflation rate difference existing between the home country and the foreign country (Antweiler 1).
For example, if the United States is experiencing an inflation rate of 4 percent while that in Europe is 2 percent, the dollar will weaken against the euro by 2 percent per year (4%-2%). This is more true when the difference in the rate of inflation is quite large.
About comparison between the dollar’s and the euro’s purchasing power in each other’s domestic economy, the law of Purchasing Power Parity (PPP) can be expressed as follows (“Purchasing Power Parity” 1):
(I) VOE = PUS/PE = Purchasing Power Parity
That is, the exchange rate between Europe’s currency and the United States’ currency (EE/USD) is equal to the price level in Europe (PE) divided by the US price level (PUSA).
Holding interest rates the US and the UK are held constant;
PUS = (PE) (VOE)
1 + %DPUS = (1 + %DPE) (1 + %DVOE)
but % DP = P = inflation rate, thus
(II) 1 + PUS = (1 + PE) (1 + AOE)
If, for example, the price level ratio PUSD/PE implies a purchasing power parity exchange rate of 1.2 USD for each euro, and that the prevailing exchange rate USD/Euro is 1.5 USD per euro, the US dollar would get stronger against the euro (“Purchasing Power Parity” 1).
Four reasons why the concept of PPP tents to fail empirical tests
The theory of PPP fails to put into consideration the fact that transaction costs make up a significant part of the price of commodities. Such costs include taxes, transport costs, as well as tariffs, and other barriers to international trade, and they differ significantly from one country to another. Thus, this reality tends to poke holes in the Law of One Price, upon which the PPP concept has its foundations (Antweiler1).
Moreover, it is difficult to compare the PP of currencies between the two countries since consumers in different countries tend to consume their unique basket of goods as well as services. Yet the PPP theory makes the analysis of the PP of two currencies in each others’ domestic economies under a key assumption that the same basket of goods is available for consumption in the two countries (Carbaugh 406).
Also, it is quite easily notable that the law of one price can only apply to movable goods. Goods which can not be transferred from one market to another, such as houses, and most services, can not be included in the basket of commodities upon which a comparison of the PP of two currencies in two markets can effectively be made.
Finally, PPP theory makes a further assumption that a competitive market exists in the two countries whose currencies’ PPs are compared relative to each other (Carbaugh 402). This is not always the case as there could be present in a free market many externalities with huge impacts on production costs hence prices of commodities.
In sum, it is well established that both relative and absolute PPP hold more closely in the short-term as compared to in the long-term (A.Taylor and M.Taylor 138). Both, also, appear to hold much better between price indices for producers than the same between consumers.
Antweiler, Werner. Purchasing Power Parity. 2011. Web.
Carbaugh, Robert J. International Economics, 12th ed. Mason, Ohio: South-Western Cengage Learning, 2008. Print.
“Purchasing Power Parity”. 1998. Web.
Taylor, Alan M., and Mark P. Taylor. “The Purchasing Power Parity Debate”. Journal of Economic Perspectives 18.4 (2004): 135–158.