Optimum currency area

Encyclopedia : O : OP : OPT : Optimum currency area

In economics, an optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. It describes the optimal characteristics for the merger of currencies or the creation of a new currency. The theory is used often to argue whether or not a certain region is ready to become a monetary union, one of the final stages in economic integration.

An optimal currency area may often be larger than a country. For instance, part of the rationale behind the creation of the euro is that the individual countries of Europe do not each form an optimal currency area, but that Europe as a whole does form an optimal currency area.

In theory, an optimal currency area could also be smaller than a country. Some economists have argued that the United States, for example, really consists of two optimal currency areas and that the United States should have two currencies, one for the western half and one for the eastern half.

The theory of the optimal currency area was pioneered by economist Robert Mundell.^{[#endnote_busweekMundell]} Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner.^{[#endnote_Lerner]}

Contents

1 Criteria
2 Notes
3 References
4 See also

Criteria

The three principal characteristics of an OCA are that there be:

Labor mobility across the region. This includes physical ability to travel (visas, worker's rights, etc.), lack of cultural barriers to free movement (such as different languages) and institutional arrangements (such as the ability to have superannuation transferred and to the new region).
Openess with capital mobility and price and wage flexibility across the region. This is so that the market forces of supply and demand automatically distribute money and goods to where they are needed. In practice this does not work perfectly as there is no true wage flexibility.(Ronald McKinnon)
An automatic fiscal transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics. This usually takes the form of taxation redistribution to less developed areas of a country/region. This policy, though theoretically accepted, is politically difficult to implement as the better-off regions rarely give up their revenue easily.

Additional criteria suggested for the OCA theory are:

Production diversification (Peter Kenen)
Homogeneous preferences
Commonality of destiny

The primary criticism of Mundell's theory is that the only area that has optimal conditions for a single currency is one that already has a single currency. A circular argument. Furthermore many existing currency areas do not fulfil these requirements.

This theory has been most frequently applied in recent years to the Euro and the European Union. By these criteria the European Union does not constitute an Optimal Currency Area and therefore the Euro should not be a successful union of currencies. However it is hoped that the creation of the Euro will in itself help encourage the conditions enumerated by Mundell.

Notes

↑ http://www.businessweek.com/1999/99_43/b3652085.htm
↑ Tibor Scitovsky. "Lerner's Contribution to Economics." Journal of Economic Literature, Vol. 22, No. 4. (Dec., 1984), pp. 1547-1571. http://links.jstor.org/sici?sici=0022-0515%28198412%2922%3A4%3C1547%3ALCTE%3E2.0.CO%3B2-R (subscription required)

References

Baldwin, Richard and Charles Wyplosz. The Economics of European Integration. New York: McGraw Hill, 2004.

Optimum currency area

Criteria

Notes

References

See also