The notion of currency substitution is widely used among countries; it can occur due to a union of countries on a specific territory or monetary disintegration when a country or countries issue its/their own money. The question regarding which option is more economically justified could be answered by comparing economic benefits and loses. The paper is mainly focused on an optimum currency area; it will be discussed using the well-known and most researched example, the Economic and Monetary Union of European countries (EMU). The paper doesn’t take into consideration the original motives of the establishment of EMU, which were political in nature, and this work is aimed at reviewing the issue of EMU from an economic point of view.

An analysis will be presented in four stages:

  • definition of an optimum currency area,
  • analysis of the EMU,
  • determination of its fragility
  • making a conclusion whether the EMU is more prone to experience sovereign debt crisis than countries having their own monetary systems.

Definition of an Optimum Currency Area

The country, which is a member of the EMU, is a country which has adopted the euro as the single currency; issuance of euro banknotes is authorized by the European Central Bank (Pilbeam, 2013). In contrast, in California dollar bills are issued with signs stating that they belong to the Central Bank of California. A dollar bill issued in California has the same value as any dollar bill issued by other federal banks of the USA. This is an example of a currency with the irrevocable conversion rate (Copeland, 2014). Thus, a single currency zone is an area in which the entire region shares a single currency or where the exchange rate is irrevocable (Copeland, 2014). Many people wonder whether it is better for a country to have its own currency or currency substitution may bring economic benefits.

First of all, it is important to answer a question regarding how those benefits appear. A number of territories are united and a single currency is introduced. Thus, the following benefits can be seen: elimination of transaction costs, removal of the uncertainty of exchange rate fluctuations, and simplification of the establishment of the long-term contractual relationships due to the use of the international unit of account (Copeland, 2014).

On the other hand, it is also beneficial for a country to have its own currency and to be able to set its own monetary policy (Oxford Economics, 2010). Countries can use measures to respond to a crisis, to control inflation, to devaluate their currency in order to promote exports or to manage their debt (Harari, 2014). Those measures are not available in the case when all those functions are given to one center and a policy should be applied to all countries even though the state of the economy of each country can be very different.

An exchange rate is a significant tool used to influence the economic situation of a country’s (De Grauwe, 2011). When the Eurozone was established, countries’ exchange rates were not as important as they are now. This economic indicator has grown due to the process of globalization.

To sum up, an optimum currency area should be established in such a way that economic benefits outweigh losses for countries with a common currency. Moreover, being a part of a union should be more profitable than being independent.

Is EMU an Optimum Currency Area?

Eurozone is a monetary union, but the question is whether it is an optimum currency area. As it was stated above, the latter can be achieved when benefits of being a part of a union overweigh losses; moreover, being in a union should provide a country with more benefits as if the country is independent.

The costs and difficulties related to currency exchange are no longer important. When a consumer purchases something there is usually no difference in which currency the purchase is paid as it is easily converted (Oxford Economics, 2010). Online computation made currency exchange easy. Moreover, according to estimations made by economists, on microeconomic level expenses related to currency exchange account for 1% of EU income; costs of uncertainty are symmetric, so when one country saves, another country losses; the gain of international unit of account is inessential (Copeland, 2014).

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The macroeconomic consequences of the monetary union are more complicated to analyze and estimate as there are many factors to be taken into consideration. The main drawback of the euro is a single fiscal policy for a number of countries which are very diverse in many aspects. For instance, the countries have different paces of growth, state of development, work ethic, natural resources and so on (Oxford Economics, 2010). A common monetary policy means that the central bank establishes interest rates for the whole Eurozone, when, for example, the economy of Germany is much more stable than the economy of Spain. Cheap credits for growing countries significantly increased consumer spending and housing market. In its turn, it triggered the growth of unit costs and the labor costs which increased the account deficit and then the budget deficit (Harari, 2014).

Moreover, it should be noticed that the monetary policy of all countries in the Eurozone was managed very wisely and it was much better formed than, for example, the monetary policy of the UK (Feldstein, 2012). However, the problems started when the decision was made to create one center responsible for the monetary policy instead of each country being responsible for it. When a country enters the Eurozone, there is a set of requirements and reforms that should be implemented along with the standards that the country should follow (Pilbeam, 2013). For example, in 2009 Greece made an announcement about a shift in the budget deficit from 6.7% of GDP to 12.7% (Feldstein, 2012). Investors started to predict the Greek debt crisis and many feared that it could spread to other countries of the Eurozone. Hence, volatility is great and problems faced by one country affect the whole union.

To conclude, the macroeconomic effects of the Eurozone seem to be negative and microeconomic gains are too small.  It is mainly due to the diversity of the countries. Hence, the Eurozone shall not be considered as an optimum currency area.

The fragility of the Eurozone

The fragility of the Eurozone is due to the lack of liquidity (De Grauwe, 2011). This causes fear among traders and investors. In case of the crisis, the economic slowdown is most likely to happen, which will lead to the cash shortage. Such a situation leads to two other possible outcomes: it will trigger interest rates and investors who managed to sell their bonds will look for more reliable investments. The only thing left for governments is to regulate their interest rates (De Grauwe, 2011).

The liquidity crisis triggers a solvency crisis. High-interest rates lead to a recession that reduces revenues. When revenues are decreasing, the debt and the deficit increase. It may even lead to a default. Even though it may not happen, the investors, who fear such a possibility, will push the country into insolvency (De Grauwe, 2011).

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On the other hand, when a country has its own monetary system and is able to manage its own fiscal policy, it has more control and has more possibilities to manage crisis and prevent default. Of course, in the case of Greece, the default was prevented as the country was bailed out with the help of other Eurozone countries (Feldstein, 2012). However, implications of this action had worsened the situation all over other countries. Hence, the fragility of the union is caused by losses as a result of a crisis in a single country or in the whole union.

Sovereign Debt Crises

The question whether countries in a monetary union are more prone to experience sovereign debt crises can be answered by comparing economic indicators for Eurozone countries with those countries, which have their own currency. Such an analysis has been already made by economists and its findings will be presented in this paper (Attinasi, 2009). Two analyses have been made: the first one for Eurozone countries, namely Ireland, Greece and Portugal and the second one for the developed countries with their own currency, namely: UK, US, Canada, Denmark, Sweden, Japan, Norway, and Switzerland.

government bond yield spreads and debt to GDP ratios for Eurozone countries

Figure 1. Government bond yield spreads and debt to GDP ratios for Eurozone countries before and after the crisis of 2008. Source: Eurostat

Government bond yield spreads and debt to GDP ratios for countries with their own currency

Figure 2. Government bond yield spreads and debt to GDP ratios for countries with their own currency before and after the crisis of 2008. Source: OECD

Those figures present clear evidence that an effect of debt-to-GDP ratios on government bond rates of Eurozone countries was different as compared to countries with their own currency, which have not been affected that much (Lane, 2012). The 2008 economic crisis had negative consequences for many countries of the world. Of course, the findings may differ from the chosen example set, but still, the contrast is evident for Eurozone countries.

The other findings of the analysis are (Lane, 2012):

  1. The debt-to-GDP ratio drastically influences the governments` bond rates of Eurozone countries when countries with their own currency are less affected by the same correlation.
  2. The fragility of Eurozone countries is mostly due to the variation of debt-to-GDP ratios, which is observed with the high magnitude and has a non-linear correlation.


The high debt-to-GDP ratio has a negative impact on countries making them more prone to experience a sovereign debt crisis. High debt-to-GDP ratios drastically increase government bonds spread and trigger other related problems. An optimum currency area is possible to survive when countries in it are united by the same level of development, stick to one monetary policy, and are open about their economic situation.

Reference List

  1. Attinasi, M, Checherita, C, Nickel, What explains the surge in Euro area sovereign spreads during the financial crisis of 2007-09, ECB, Working paper, no. 1131.
  2. Copeland, L, 2014, Exchange rates and international finance, Prentice Hall, 6th Ed.
  3. European Commission statistics database.
  4. Feldstein, M 2012, The failure of the Euro, The Foreign Affairs, viewed 8 November 2014.
  5. Harari, D 2014, Causes of the eurozone crisis: a summary, The House of Commons Library viewed 8 November 2014.
  6. Lane, Ph,  ‘The European sovereign debt crisis’, Journal of Economic Perspectives, vol. 26, no. 3, pp. 49–68.
  7. OECD, Economic data.
  8. Oxford Economics 2010, European sovereign debt crisis: how might it impact your business? Viewed 9 November 2014.
  9. Pilbeam, K 2013, Internationa finance, Palgrave Macmillan, 3rd ed., Ch. 16.
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