Investor concern about certain countries in a currency area is destabilising for them, whereas it is stabilising for countries in a flexible exchange rate regime

The euro zone offers a prime example of this mechanism. If investors are concerned about the situation of certain countries in a currency area (because they have high public debt, external deficits or low potential growth), capital outflows from these countries will drive apart their yield spreads against other countries. The rise in interest rates in the struggling countries exacerbates their situation, so the currency area functions in a destabilising manner. In a flexible exchange rate regime, the same capital outflows cause a depreciation of the exchange rate in the struggling countries, rather than a rise in interest rates. This exchange rate depreciation, which improves the countries’ competitiveness, is then stabilising. This is a clear weakness of currency areas.