Optimal Currency Area

Optimum currency area

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 may often be 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.

In theory, an optimal currency area could also be smaller than a country. Some economists have argued that the United States, 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. and Japan.
  • Product diversification: The Eurozone scores quite well on this criterion, and monetary integration seems to further improve the diversification of production structures.
  • 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.

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. 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.

See also

Notes

  1. http://www.businessweek.com/1999/99_43/b3652085.htm
  2. Tibor Scitovsky. "Lerner's Contribution to Economics." Journal of Economic Literature, Vol. 22, No. 4. (Dec., 1984), pp. 1547-1571. http://links.jstor.org/sici?sici=0022-0515%28198412%2922%3A4%3C1547%3ALCTE%3E2.0.CO%3B2-R (subscription required)

References

  • Baldwin, Richard and Charles Wyplosz. The Economics of European Integration. New York: McGraw Hill, 2004.

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