Optimum currency area

The underlying theory 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 currency union, one of the final stages in economic integration.

An optimal currency area is often 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. The creation of the euro is often cited because it provides the most modern and largest-scale case study of an attempt to identify an optimum currency area, and provides a comparative before-and-after model by which to test the principles of the theory.

In theory, an optimal currency area could also be smaller than a country. Some economists have argued that the United States, for example, has some regions that do not fit into an optimal currency area with the rest of the country.

The theory of the optimal currency area was pioneered in the 1960s by economist Robert Mundell. Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner. Kenen (1969) and McKinnon (1963) were further developers of this idea.

Models

Optimum currency area with stationary expectations

Published by Mundell in 1961, this is the most cited by economists. Here asymmetric shocks are considered to undermine the real economy, so if they are too important and cannot be controlled, a regime with floating exchange rates is considered better, because the global monetary policy (interest rates) will not be fine tuned for the particular situation of each constituent region.

The four often cited criteria for a successful currency union are:

• Labor mobility across the region. What if we suppose instead that Home and Foreign have an integrated labor market, so that labor is free to move between them: What effect will this have on the decision to form an optimum currency area? This includes physical ability to travel (visas, workers' rights, etc.), lack of cultural barriers to free movement (such as different languages) and institutional arrangements (such as the ability to have pensions transferred throughout the region). For example, suppose Home and Foreign initially have equal output and unemployment. Suppose further that a negative shock hits Home, but not Foreign. If output falls and unemployment rises in Home, then labor will start to migrate to Foreign, where unemployment is lower. If this migration can occur with ease, the impact of the negative shock on Home will be less painful. Furthermore, there will be less need for Home to implement an independent monetary policy response for stabilization purposes. With an excess supply of labor in one region, adjustment can occur through migration.
• Openness 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. The Eurozone members trade heavily with each other (intra-european trade is greater than international trade), and early (2006) empirical analyses of the 'euro effect' suggested that the single currency had already increased trade by 5 to 15 percent in the Eurozone when compared to trade between non-euro countries.
• A risk sharing system such as 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. Theoretically, Europe has a no-bailout clause in the Stability and Growth Pact, meaning that fiscal transfers are not allowed. During the 2010 Eurozone crisis (relating to government debt), the no-bailout clause was de facto abandoned in April 2010. Subsequent theoretical analysis suggests that this was always an unrealistic expectation. Federations and decentralized countries typically give subsidies to poorer regional governments (e.g. equalization payments in Canada).
• Participant countries have similar business cycles. When one country experiences a boom or recession, other countries in the union are likely to follow. This allows the shared central bank to promote growth in downturns and to contain inflation in booms. Should countries in a currency union have idiosyncratic business cycles, then optimal monetary policy may diverge and union participants may be made worse off under a joint central bank.

Additional criteria suggested are:

• Production diversification (Peter Kenen)
• Homogeneous preferences
• Commonality of destiny ("Solidarity")

Optimum currency area with international risk sharing

Here Mundell tries to model how exchange rate uncertainty will interfere with the economy; this model is less often cited.

Supposing that the currency is managed properly, the larger the area, the better. In contrast with the previous model, asymmetric shocks are not considered to undermine the common currency because of the existence of the common currency. This spreads the shocks in the area because all regions share claims on each other in the same currency and can use them for dampening the shock, while in a flexible exchange rate regime, the cost will be concentrated on the individual regions, since the devaluation will reduce its buying power. So despite a less fine tuned monetary policy the real economy should do better.

A harvest failure, strikes, or war, in one of the countries causes a loss of real income, but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future. If, on the other hand, the two countries use separate monies with flexible exchange rates, the whole loss has to be borne alone; the common currency cannot serve as a shock absorber for the nation as a whole except insofar as the dumping of inconvertible currencies on foreign markets attracts a speculative capital inflow in favor of the depreciating currency.

— Mundell, 1973, Uncommon Arguments for Common Currencies p. 115

Mundell's work can be cited on both sides of the debate about the euro. However, in 1973 Mundell himself constructed an argument on the basis of the second model that was more favorable to the concept of a (then-hypothetical) shared European currency.

Rather than moving toward more flexibility in exchange rates within Europe the economic arguments suggest less flexibility and a closer integration of capital markets. These economic arguments are supported by social arguments as well. On every occasion when a social disturbance leads to the threat of a strike, and the strike to an increase in wages unjustified by increases in productivity and thence to devaluation, the national currency becomes threatened. Long-run costs for the nation as a whole are bartered away by governments for what they presume to be short-run political benefits. If instead, the European currencies were bound together disturbances in the country would be cushioned, with the shock weakened by capital movements.

— Robert Mundell, 1973, A Plan for a European Currency pp. 147 and 150