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 Monetary System - EMS

    A 1979 arrangement between several European countries which links ...
  5. European Sovereign Debt Crisis

    A period of time in which several European countries faced the ...
  6. Soft Currency

    A currency with a value that fluctuates as a result of the country's ...
Related Articles
  1. 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 ...
  2. 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 ...
  3. Forex Education

    One World, One Currency: Could It Work?

    This idea has been debated for decades, but could it really work? Which countries would benefit? What are the downfalls? How would supply and printing factor in?
  4. Term

    Why Countries Keep Reserve Currency

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

    What Happens in a Currency Crisis?

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

    Forex Currencies: The EUR/USD

    By Brian PerryThe United States and the European Union are the two largest economic entities in the world. The U.S. dollar is the world's most heavily traded and most widely held currency. The ...
  7. Forex Fundamentals

    The Effects Of Currency Fluctuations On The Economy

    Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by ...
  8. Forex Education

    Dollarization Explained

    Find out how fledgling economies can find some stability in their currency and attract foreign investment.
  9. Forex Education

    How The Triffin Dilemma Affects Currencies

    Countries that issue reserve currencies are faced with a dilemma: keep other countries happy or achieve domestic monetary policy goals.
  10. Forex

    Main Factors That Influence Exchange Rates

    The exchange rate is one of the most important determinants of a country's relative level of economic health, and can impact your returns.
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 key economic factors that can cause currency depreciation in a country?

    Read about the causes of currency devaluation, and find out how to differentiate between relative and absolute currency devaluation. Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center