Currency Zone

A currency zone or optimum currency area is defined as a geographical region in which there is a single currency or several currencies that are pegged to each other so that the currencies can fluctuate only against the rest of the world. Currency zones eliminate exchange rate uncertainties and maximize economic stability within that area. The most prominent example of a currency zone is the Eurozone in which the European Union member states have decided to abandon their domestic currencies and adopt the euro as their single currency.

The optimum currency zone theory, first published by R. Mundell (1961), along with the theory of comparative advantage of David Ricardo, are the most cited theories in international economics that have also seen widespread applications in recent decades.

The benefits associated with the adoption of a single currency are twofold: First, the elimination of transaction costs and, second, the minimization of risk originating from exchange rate uncertainties. In particular, it is argued that the most visible gain of a monetary union is the removal of costs associated with exchanging one currency into another. Yet, even though this benefit is relatively small, less than half of 1 percent of the Eurozone GDP, it should be added to the overall benefits of a single currency. These benefits mainly refer to the increased usefulness of money. That is, a currency zone increases price transparency, decreases price discrimination within the zone, and in general fosters competition. So, a currency zone promotes trade between the member-states of the zone, increases efficiency in the allocation of resources, and endorses cross-area foreign direct investment.

The second major advantage of a currency zone is that it reduces the exchange rate uncertainty risk. Even when two or more currencies are narrow-banded to each other, like in the case of the Exchange Rate Mechanism, there is still some exchange rate risk associated with the individual currencies. This risk is eliminated when a single currency is introduced to replace the old monetary system. The indirect welfare gains that come from a currency zone are said to help firms increase their efficiency by eliminating the uncertainty about the future prices of good and services. This, in turn, should increase economic growth within that area. At the same time, a single currency removes from single countries their ability to print money; thus, inflationary pressures to single countries are eliminated.

However, skeptics of currency zones argue that the loss of the ability of individual countries to conduct a national monetary policy is more important than the benefits of a single currency. That is, a nation joining a single currency loses its ability to change interest rates, to determine the quantity of money, and to change the price of its currency. The key point is that, within a currency zone, the member countries may face the one-size-fits-all problem, which refers to the application of policies that are inappropriate for individual countries. So, for example, combating inflation within the Eurozone might have disturbing consequences for individual member states that have no inflation problems. Further, it has been argued that member states lose their ability to react to asymmetric shocks, that is, shocks that affect one economy differently from others.

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