Understanding the Eurozone Crisis: Challenges and Opportunities

THE EUROZONE CRISIS 1
The Eurozone Crisis
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THE EUROZONE CRISIS 2
Executive summary
The European Union is a region that has been facing challenges as some of its members
have been considering exiting the Union. A country like Italy thought that the Union would be
strategic in facilitating economic growth only for it to discover that its economy has remained
stagnant since its membership. The UK is another country that will be leaving the Union through
BREXIT despite numerous criticisms by various scholars. The question of whether European
Union is an optimal currency area is fundamental in this essay and as various scholars have
demonstrated, it fails to meet the conditions set to qualify as an optimal currency area as the UK
continued to use its pound despite the presence of Euro as the currency to be used in the region.

THE EUROZONE CRISIS 3
Introduction
The European Commission introduced the European Monetary System in 1979 that
entailed several countries that were part of the European Economic Community and pegged their
exchange rates based on a European Currency Unit. It is following this event that discussions
ensued over the likelihood of the Eurozone becoming an Optimal Currency Area
(Krugman,2013). The Euro got introduced in 1999 by the European Union which became
common currency. At first, the Euro served as an electronic currency that was used by banks.
However, as of January 2002, the Euro was used as bank notes and was a legal tender used by 12
countries in their transactions such as Germany, Greece, Luxembourg, Belgium and Austria
among other nations.
Is the Eurozone an optimal currency area?
Mundell postulated the optimum currency area theory in 1961 and mainly focused on
geographic areas that could benefit from using a single monetary policy with a common currency
or fixed exchange rates. The theory was a counter to arguments developed by Friedman that it is
the flexible exchange rates that facilitated correcting changes responsible for ushering in external
equilibrium. In establishing the premise that a geographical region was an optimal currency area,
Mundell conducted a series of studies on the mobility of factors with regards to labor as the
primary prerequisite.
A currency that is characterized by the high mobility of labor and other factors translated
to a high likelihood that degree for altering the real factor price was probably to be lower
(Scharpf,2015). High degree of labor mobility meant that employees could have the flexibility
and freedom of moving to different nations which could be attributed to having desirable demand

THE EUROZONE CRISIS 4
conditions in reducing the level of unemployment in their respective domestic countries. On the
other hand, wage flexibility meant that adjustment in the exchange rate in case asymmetric shock
occurred as possible, and such an adjustment originated from wage adjustments as wages are the
most vital elements of costs thus affect prices.
In the 1990s, the future of one European currency was an interesting debate, and
according to some scholars they revealed that asymmetrical shocks were more conspicuous in
European countries compared to others such as the US (Moravcsik,2012). However, some
findings revealed a correlation between the advantages to be accrued from a common currency
such as its microeconomic nature translates to minimize transaction costs and fewer risks. On the
other hand, the costs of a common currency are also microeconomic and are linked to the loss of
freedom of monetary policy and exchange rate adjustment if asymmetric shocks take root.
The flexibility of price and wage
Considering the EMU and for instance, Italy becomes a victim of asymmetric shock
which could lead to increased unemployment in Italy but not in any other country in the
European Union. In such a case, the adjustment has to originate from the relative prices in
member nations aiming to make Italy competitive thus reducing its level of unemployment.
Since the exchange rate is pegged, the adjustment has to be effected in the prices of goods and
services (Costantini et al.,2014). Wages have been found to be the vital component with regards
to costs, and thus an adjustment in the exchange rate can stem from changes in wages. Thus,
flexibility in wages becomes desirable in the context of a common currency.
Costs attached to a common currency
The primary cost associated with a common currency is that member nations are more
likely to bear suffering from asymmetric shocks. For instance, a country that gets hit by one of