Overvaluation in a non-optimal currency area

Abstract

The devaluation tool in an optimal currency area allows economic policies to adjust relative costs in front of economic shocks. Devaluation risk is due to the relationship of domestic inflation with that of a nation's trading partners. If the gap between them is not adjusted by depreciation, it will start a process of overvaluation of national currency which ends in a trade deficit, reduced gross domestic product (GDP) and rising unemployment. Devaluation or depreciation would restore the competitiveness of the productive apparatus. However, in a non-optimal currency area - as a country unilaterally dollarised - this adjustment may be made by abandoning the anchor coin and adopting a new national currency, what it has been called ‘demonetisation’ (Encinas-Ferrer, 2003a, 2003b). The Eurozone experience from 2011 shows us that abandoning a non-optimal currency area and establishing a new national currency is a decision that no one has dared to take.