The European Monetary Union and the optimal currency areas theory

The European Monetary Union and the optimal currency areas theory

The economic debate on the introduction of the euro was based on the theory of optimal currency areas, the cornerstone of which was laid by Robert Mundell  in 1961 and for which he was awarded the Nobel Prize for Economics in 1999. The theory revolves around the question of how national economies react to destabilising external disturbances. It is assumed that a disturbance can often be more easily offset by changes in exchange rates than by changes in domestic prices or wages. Thus, the existence of several currencies fulfils a useful balancing mechanism. If this mechanism is abolished, it must be replaced by others. In the literature, a monetary union requires high factor mobility, openness of economies, product diversification and integration of economic policies. To make a monetary union a success, labour markets in particular need prices and wages to be flexible enough to respond to fluctuations in product market demand by adjusting prices rather than labour volumes.

A disruption is defined as a change in demand or supply conditions triggered by exogenous influences. This can affect all participants in a monetary union symmetrically, but is then irrelevant for internal exchange ratios. In the case of an asymmetric change, the participants in the monetary union are affected differently and the relative prices and/or quantities are adjusted. Only those disruptions which adversely affect a country's wages and employment should be considered.

High wage flexibility is a condition for a successful monetary union.

An example of a disruption is a fall in demand for domestically produced goods. In order to avoid unemployment in the export sector as a result of a drop in demand, the prices in foreign currency for the exported goods must be lowered. This can be achieved in two ways: Either the price can be lowered in absolute terms by lowering the price (in the neoclassical model and other things being equal at the expense of wages) or the domestic currency can be devalued in nominal terms. In a monetary union, the second option is not possible, so the adjustment must be made by reducing domestic wages and goods prices. High wage flexibility and the ability to reduce wages significantly during or after crises (internal devaluation) are therefore conditions that must be met if a monetary union is to be successful. In addition to wage flexibility, there is a second, alternative, possibility to offset asymmetric adverse shocks: If labour mobility between the participating economies is particularly high, the migration of labour from the negatively affected areas can compensate.

The risk of wanting to establish a monetary union with these participating States was extremely high. The politicians around Mitterrand and Kohl, who were adamant about the need for this monetary union, were opposed to the economic theories and had their own hypothesis: The idea of convergence and the so-called "locomotive theory". According to this theory, a common set of rules should force the unification of economic and financial policy in the newly created currency area and thus accelerate the integration of the participants. The weaker participants should be brought closer to the German level after the introduction of monetary union.

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