Optimal Currency Area

Loading the player...

What is an 'Optimal Currency Area'

The geographic area in which a single currency would create the greatest economic benefit. While traditionally each country has maintained its own separate, national currency, work by Robert Mundell in the 1960s theorized that this may not be the most efficient economic arrangement. In particular, countries that share strong economic ties may benefit from a common currency. This allows for closer integration of capital markets and facilitates trade. However, a common currency results in a loss of each country's ability to direct fiscal and monetary policy interventions to stabilize their economies.

BREAKING DOWN 'Optimal Currency Area'

The primary test for the theory of optimal currency areas is the introduction of the euro as a common currency in many European nations. Eurozone countries matched well with Mundell's criteria for successful monetary union, providing the impetus for the introduction of a common currency. While the eurozone has seen many benefits from the introduction of the euro, it has also experienced problems such as the Greek debt crisis. Thus, the long-term outcome of monetary union under the theory of optimal currency areas remains a subject of debate.

Theory of the Optimal Currency Area

In 1961 Canadian economist Robert Mundell published his theory of the optimal currency area (OCA) with stationary expectations. He outlined the criteria necessary for a region to qualify for an optimal currency area and benefit from a common currency. In this first model, the primary difference is that if asymmetric shocks undermine a country’s economy within the OCA, a system with floating exchange rates is considered more suitable in order to concentrate the negative effects of such shocks within the single country experiencing them.

According to Mundell, there are four main criteria for an optimal currency area:

  • Increased labor mobility throughout the area. Ease of labor mobility includes the ability to travel via simplified visas, a lack of cultural barriers that inhibit free movement such as different languages, and institutional policies such as the transfer of pensions or government benefits.
  • Capital mobility and price and wage flexibility. If financial resources can move easily between areas that trade frequently with each other, this mobility can facilitate overall trade and boost economies. This also allows the market forces of supply and demand to distribute money where it is needed and maintain a balanced economic system.
  • A currency risk-sharing system across countries. A risk-sharing system in a currency union requires the distribution of money to regions experiencing economic difficulties, whether due to the adoption of the first two traits or because these areas are less developed. This criteria is controversial as it is politically difficult to sell in individual countries, as such countries with surpluses are unwilling to give up their revenue. The European sovereign debt crisis of 2009-2015 is considered evidence of the failure of the European Economic and Monetary Union (EMU) to satisfy this criteria as original EMU policy instituted a no-bailout clause which soon became evident as unsustainable.
  • Similar business cycles. All participants in the area must have similar business cycles so that economic booms are shared, and the OCA’s central bank can offset and diffuse economic recessions by promoting growth and containing inflation.

Mundell went on to amend this theory of the optimal currency area to mandate that a closer system of international risk sharing in the area was not only necessary to the success of the OCA, but crucial. In his 1973 “Uncommon Arguments for Common Currencies,” Mundell mandates that countries in surplus must mitigate market shocks by closer economic and institutional integration via “reserve pooling” or revenue sharing. Thus, a floating exchange rate that concentrates a economic shock in the country from which it originates is not a fitting criteria for an OCA. Instead, because the currency is shared and the overall economy of the region would benefit from absorbing economic shock as a whole, placing the burden of recession and devaluation in one country or region alone is unsustainable.

Greece, the European Sovereign Debt Crisis and the OCA

The euro is the largest and most recent example of an optimal currency area. Since the rise of the EMU and the adoption of the euro by participating European countries in 2002, the subsequent ongoing European sovereign debt crisis is cited as evidence that the EMU did not fit the criteria for a successful OCA. Other than arguable cultural barriers such as different languages, the EMU did not adequately provide for the greater economic integration necessary for cross-border risk sharing. As Greece’s sovereign debt crisis continues to worsen in 2015, it is speculated that the EMU must account for risk-sharing policies far more extensive than the current provisionary bailout system.  

RELATED TERMS
  1. Robert A. Mundell

    The winner of the 1999 Nobel Prize in Economics for his research ...
  2. Currency Union

    When two or more groups (usually countries) share a common currency ...
  3. Optimum Currency Area Theory

    A currency thoery based on geographical area that adopts a fixed ...
  4. European Economic and Monetary ...

    The successor to the European Monetary System (EMS), the combination ...
  5. European Monetary System - EMS

    A 1979 arrangement between several European countries which links ...
  6. Currency

    Currency is a generally accepted form of money, including coins ...
Related Articles
  1. Forex Education

    The Euro: What Every Forex Trader Needs To Know

    Find out the reports and events that determine the euro's worth, and how we can predict movements in its valuation.
  2. Forex Education

    Forex Currencies: Conclusion

    By Brian Perry Conclusion The currency markets are the largest and most actively traded financial markets in the world with daily trading volume of more than $3 trillion (Triennial Central ...
  3. Forex Education

    Forex Tutorial: Economic Theories, Models, Feeds & Data

    There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the ...
  4. Economics

    What Are The Advantages Of Not Adopting The Euro?

    European Union countries that do not use the euro have a few advantages over eurozone countries. Investopedia explores how.
  5. Term

    Why Countries Keep Reserve Currency

    Central banks and financial institutions hold large amounts of foreign money as their reserve currency.
  6. Economics

    Why the Euro Failed to Become the World's Reserve Currency

    Examine the current state of the U.S. dollar as the world's reserve currency; learn the major reasons why the euro has failed to replace it in that capacity.
  7. Markets

    What Happens in a Currency Crisis?

    A currency crisis comes from a decline in the value of a country’s currency.
  8. Forex

    Economic Theories

    Economic indicators can have a huge impact on the market. Getting to know them is essential for forex traders.
  9. Forex Education

    A Primer On Currency Regimes

    Currency regimes are dynamic and complex, reflecting the ever-changing landscape of their respective nations' monetary and fiscal policies.
  10. Economics

    Why These European Countries Don't Use The Euro

    The euro is a common currency of the European Union. Yet, many EU countries don’t use the euro. Investopedia explores why.
RELATED FAQS
  1. When and why did the euro make its debut as a currency?

    On January 1, 1999, the European Union introduced its new currency, the euro. Originally, the euro was an overarching currency ... Read Answer >>
  2. What is foreign exchange?

    Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's ... Read Answer >>
  3. How does inflation affect the exchange rate between two nations?

    Understand how inflation can affect foreign exchange rates of a currency and how it is just one of many economic factors ... Read Answer >>
  4. What are key benefits to a country that has engaged in a policy of currency depreciation?

    Learn about key benefits to a country engaging in a policy of currency depreciation, such as smaller trade deficits, employment ... Read Answer >>
  5. How do changes in national interest rates affect a currency's value and exchange ...

    Understand the role that changes in interest rates can play in determining the value and foreign exchange rate of a country's ... Read Answer >>
  6. What are the typical day-to-day responsibilities of a Chief Operating Officer (COO)?

    Learn how a country's debt crisis affects the world, including how currency values, inflation and output are affected on ... Read Answer >>
Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center