What is the Optimum Currency Area Theory (OCA)

Optimum currency area theory (OCA) states that specific areas which are not bounded by national borders would benefit from a common currency. The theory holds that a geographical area should adopt a fixed exchange rate administration between currencies or a single currency within its geographic boundaries. Optimum currency area theory can benefit a region by significantly increasing trade. However, this trade must outweigh the costs of giving up a national currency as an instrument to adjust monetary policy. Areas using OCA theory will still maintain a flexible exchange rate system with the rest of the world.

BREAKING DOWN Optimum Currency Area Theory (OCA)

Optimum currency area theory (OCA) was developed in 1961 by Canadian economist Robert Mundell based on earlier work by Abba Lerner. It speculates that there is an optimum geopolitical area which should share a currency, but this geopolitical area doesn’t necessarily correspond with national borders. An optimum currency area could be several nations, parts of several nations, or regions inside a single nation.

The theory states that there are four criteria for an optimum currency area:

  1. A large, available, and integrated labor market which allows workers to move freely throughout the area and smooth out unemployment in any single zone.
  2. The flexibility of pricing and wages, along with the mobility of capital, to eliminate regional trade imbalances.
  3. A centralized budget or control to redistribute wealth to parts of the area which suffer due to labor and capital mobility.
  4. The participating regions have similar business cycles and timing for economic data to avoid a shock in any one area.

Princeton professor and international economist, Peter Kenen, suggested the adding of a fifth criterion of production diversification within the geopolitical area.

Some economists also argue that the United States should be divided into several smaller currency areas, as the country as a whole does not fit the criteria listed in Mundell’s original OCA theory. Economists have calculated that the Southeast and Southwest regions of the United States do not necessarily fit with the rest of the country as an optimum currency area.

Question Remain on the Euro as an Optimum Currency Area

Often cited as a prime example of optimum currency theory, many point to the euro as proof of OCA theory in action. However, some argue that the area did not meet the four criteria as laid out by Mundell’s theory at the time of the euro's creation in 1991. This lack of meeting the requirements, they say, is the reason the Eurozone has struggled since its inception. 

Indeed, the OCA theory was put to the test in 2010 as sovereign debt issues faced by many heavily indebted nations in Europe threatened the viability of the European Union, and placing severe strains upon the euro. 

According to Global Financial Integrity, a non-profit located in Washington, D.C., peripheral EU countries such as Ireland, Portugal, Spain, and Greece experienced slowing growth, lacked international competitiveness, and possessed a labor force which is unproductive.  As these economies slowed, private capital fled, some to other stronger eurozone economies, and some to other countries. Also, due to language, culture, and distance difficulties the labor force in the eurozone is not fluid or mobile. Wages are not uniform across the geopolitical area either.