Optimal Currency Area

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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.

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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.  

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