Optimal Currency Area

AAA

DEFINITION of '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.

INVESTOPEDIA EXPLAINS '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.  

VIDEO

Loading the player...
RELATED TERMS
  1. Robert A. Mundell

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

    A currency system that establishes a trading range that a currency's ...
  3. Currency

    A generally accepted form of money, including coins and paper ...
  4. Quote Currency

    The second currency quoted in a currency pair in forex. In a ...
  5. European Union - EU

    A group of European countries that participates in the world ...
  6. Currency Pair

    The quotation and pricing structure of the currencies traded ...
RELATED FAQS
  1. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
  2. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>
  3. Which is more important to a nation's economy, the balance of trade or the balance ...

    There is no question the composition of a country's balance of payments is more important than its balance of trade. This ... Read Full Answer >>
  4. What are the ethical arguments against government subsidies to companies like Tesla?

    The ethical argument behind government subsidies is that they should be put into place to help industries that will, in turn, ... Read Full Answer >>
  5. How can tariffs cause inefficiencies in domestic industries?

    Any government regulation naturally creates inefficiencies in a pure supply and demand marketplace. When it comes to the ... Read Full Answer >>
  6. How do changes in interest rates affect the spending habits in the economy?

    Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including ... Read Full Answer >>
Related Articles
  1. Personal Finance

    The Currency Board: Understanding The Government's Bank

    Currency board, central bank - what's the difference? Find out more about this little-known monetary authority.
  2. Forex Education

    Top 7 Questions About Currency Trading Answered

    Whether you're puzzled by pips or curious about carry trades, your queries are answered here.
  3. Forex Education

    Dollarization Explained

    Find out how fledgling economies can find some stability in their currency and attract foreign investment.
  4. Personal Finance

    What Are Central Banks?

    They print money, they control inflation, and much, much more. All you need to know about central banks is here.
  5. Forex Education

    The International Money Market

    Banks, corporations, traders and speculators all use the IMM to borrow, lend, trade, profit, finance, speculate and hedge risks.
  6. Economics

    What Does Infrastructure Mean?

    Examples of infrastructure include mass transit, communication, sewage, water and electric systems, plus roads, bridges and tunnels.
  7. Economics

    Calculating the GDP Price Deflator

    The GDP price deflator adjusts gross domestic product by removing the effect of rising prices. It shows how much an economy’s GDP is really growing.
  8. Economics

    What's a Centrally Planned Economy?

    A centrally planned economy is one where the government controls the country’s supply and demand of goods and services.
  9. Economics

    Why The Dollar’s Strength Can Continue

    Overall, the U.S. dollar has rallied this year, with the Dollar Index (DXY) now up by roughly 8 percent year-to-date, but the gain hasn’t been steady.
  10. Economics

    How Iran Impacts The Price and Supply of Oil

    If Congress approves the deal, Iranian oil will be widely available for the first time in years. When Iranian oil begins to flood the market, it will influence the world oil supply and oil prices ...

You May Also Like

Hot Definitions
  1. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
  2. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  3. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
  4. Investopedia

    One of the best-known sources of financial information on the internet. Investopedia is a resource for investors, consumers ...
  5. Unfair Claims Practice

    The improper avoidance of a claim by an insurer or an attempt to reduce the size of the claim. By engaging in unfair claims ...
  6. Killer Bees

    An individual or firm that helps a company fend off a takeover attempt. A killer bee uses defensive strategies to keep an ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!