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In economics, an optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. It describes the optimal characteristics for the merger of currencies or the creation of a new currency. The theory is used often to argue whether or not a certain region is ready to become a monetary union, one of the final stages in economic integration.

An optimal currency area is often larger than a country. For instance, part of the rationale behind the creation of the euro is that the individual countries of Europe do not each form an optimal currency area, but that Europe as a whole does form an optimal currency area. The creation of the euro is often cited because it provides the most modern and largest-scale case study of the engineering of an optimum currency area, and provides a comparative before-and-after model by which to test the principles of the theory.

In theory, an optimal currency area could also be smaller than a country. Some economists have argued that the United Statesmarker, for example, really consists of two optimal currency areas and that the United States should have two currencies, one for the western half and one for the eastern half.

The theory of the optimal currency area was pioneered by economist Robert Mundell.Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner.

Models

Mundell came up with two models.

OCA with stationary expectations

Published by Mundell in 1961, this is the most cited by economists. Here asymmetric shocks are considered to undermine the real economy, so if they are too important and cannot be controlled, a regime with floating rates is considered better, because the global monetary policy (interest rates) will not be fine tuned for the particular situation of each constituent region.

The four principal criteria for a successful currency union are:

  • Labor mobility across the region. This includes physical ability to travel (visas, workers' rights, etc.), lack of cultural barriers to free movement (such as different languages) and institutional arrangements (such as the ability to have superannuation transferred throughout the region) (Robert A. Mundell). In the case of the Eurozone, while capital is quite mobile, labour mobility is relatively low, especially when compared to the U.S.marker and Japanmarker.


  • Openness with capital mobility and price and wage flexibility across the region. This is so that the market forces of supply and demand automatically distribute money and goods to where they are needed. In practice this does not work perfectly as there is no true wage flexibility. (Ronald McKinnon). The Eurozone members trade heavily with each other (intra-European trade is greater than international trade), and most recent empirical analyses of the 'euro effect' suggest that the single currency has increased trade by 5 to 15 percent in the euro-zone when compared to trade between non-euro countries.


  • An automatic fiscal transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics. This usually takes the form of taxation redistribution to less developed areas of a country/region. This policy, though theoretically accepted, is politically difficult to implement as the better-off regions rarely give up their revenue easily. Theoretically, Europe has no bail-out clause in the Stability and Growth Pact, meaning that fiscal transfers are not allowed, but it is impossible to know what will happen in practice.


While Europe scores well on some of the measures characterising an OCA, it has lower labour mobility than the United States and similarly cannot rely on fiscal federalism to smooth out regional economic disturbances. Also, its Gini coefficient of 31 should have a stabilizing effect; in comparison, the USA has a Gini index of 46.9 (lower is better).

Additional criteria suggested are:
  • Production diversification (Peter Kenen)
  • Homogeneous preferences
  • Commonality of destiny


This theory has been most frequently applied in recent years to the euro and the European Union. Despite the promenience of the EU as the primary case study of a OCA, many have argued that the EU does actually not meet the criteria for an OCA. By these criteria the European Union does not constitute an Optimal Currency Area and therefore the euro should be a suboptimum union of currencies. However it is hoped that the creation of the euro will in itself help encourage the conditions enumerated by Mundell.

The primary criticism of Mundell's theory is that the only area that has optimal conditions for a single currency is one that already has a single currency, a circular argument. Furthermore, many existing currency areas do not fulfill these requirements.

OCA with international risk sharing

Here Mundell tries to model how exchange rate uncertainty will interfere with the economy; this model is less often cited (publication in 1973).

Supposing that the currency is managed properly, the larger the area, the better. In contrast with the previous model, asymmetric shocks are not considered to undermine the common currency because of the existence of the common currency. This spreads the shocks in the area because all regions share claims on each other in the same currency and can use them for dumping the shock, while in a flexible exchange rate regime, the cost will be concentrated on the individual regions, since the devaluation will reduce its buying power. So despite a less fine tuned monetary policy the real economy should do better.

Robert A. Mundell is found in both sides of the debate about the euro. Most economists cite preferentially the first (stationary expectations) and conclude against the euro, yet Mundell advocates this one, and concludes in favour of the euro.

Criticism

The notion of a currency that does not accord with a state, specifically one larger than a state – formally, of an international monetary authority without a corresponding fiscal authority – has been criticized by Keynesian and Post-Keynesian economists, who emphasize the role of deficit spending by a government (formally, fiscal authority) in the running of an economy, and consider using an international currency without fiscal authority be a loss of "monetary sovereignty".

Specifically, Keynesian economists argue that fiscal stimulus in the form of deficit spending may be necessary to fight unemployment, which is not possible if states in a monetary union are not allowed to run sufficient deficits.The Post-Keynesian theory of Neo-Chartalism holds that government deficit spending creates money, that ability to print money is fundamental to a state's ability to command resources, and that "money and monetary policy are intricately linked to political sovereignty and fiscal authority". Both of these critiques consider the transactional benefits of a shared currency to be minor compared to these drawbacks, and more generally place less emphasis on the transactional function of money (a medium of exchange) and greater emphasis on its use as a unit of account.

See also



References

  1. Baldwin, Richard and Charles Wyplosz. The Economics of European Integration. New York: McGraw Hill, 2004.
  2. Mundell, R.A. (1961), "A Theory of Optimum Currency Areas", American Economic Review 51: 657-665.
  3. http://www.businessweek.com/1999/99_43/b3652085.htm
  4. Tibor Scitovsky. "Lerner's Contribution to Economics." Journal of Economic Literature, Vol. 22, No. 4. (Dec., 1984), pp. 1547-1571 (see pp. 1555-6 for discussion of OCA). http://links.jstor.org/sici?sici=0022-0515%28198412%2922%3A4%3C1547%3ALCTE%3E2.0.CO%3B2-R (subscription required)
  5. Baldwin, Richard, 2006, In or Out: Does it Matter? An Evidence-Based Analysis of the Euro's Trade Effects, London. http://hei.unige.ch/~baldwin/PapersBooks/Euro%20Book%20Manuscript%209May06.pdf
  6. Ricci, Luca A. "A Model of an Optimum Currency Area." A Working Paper for the International Monetary Fund. June 1997. http://www.imf.org/external/pubs/ft/wp/wp9776.pdf



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