Optimum Currency Areas

Economies form a currency area if they use the same legal tender or have their exchange rates irrevocably fixed. An optimum currency area is a theoretical notion, which suggests extending the size of a currency area to the point where the benefits of using a common currency just outweigh the costs of giving up one's own currency. The literature on what determines the possible benefits and costs flourished until about the mid-1970s and then fell into oblivion.

European monetary integration led to a renaissance of the theory of optimum currency areas (OCA), culminating in the 1999 award of the Nobel Prize to Robert Mundell. His seminal article in 1961 framed the problem of forming a currency area in purely economic terms. It amounts to a cost-benefit analysis of irrevocably fixing the exchange rate. Countries that form a currency area lose, on the one hand, the exchange rate as a presumably effective instrument of adjustment to shocks that affect these economies differently. On the other hand, the member countries of a currency area benefit from lower transaction costs of switching between currencies. The optimum size is reached when the loss from higher adjustment costs are equal to the gains from using fewer currencies.

The benefits of lower currency transaction costs were straightforward and did not arouse much interest, while the determinants of rising adjustment costs became an ever-longer list. Increasing adjustment costs are of less concern, first, if shocks affect the countries or regions in similar ways so that a devaluation or revaluation of the exchange rate would not help. This is the case if the countries in question have a diversified or a similar economic structure. If shocks are asymmetric, however, the costs of forming a currency area can still be manageable if, secondly, other adjustment instruments can substitute for the exchange rate. These other adjustment mechanisms—or “OCA criteria,” as they are called by scholars in the field—comprise labor mobility and to a lesser degree capital mobility, flexible prices or monetary wages, and fiscal federalism. Whenever a member of the currency area suffers more from unemployment or inflation as a consequence of a shock, these market mechanisms or government policies would replace exchange-rate changes that otherwise could have led to rising employment (devaluation) or the easing of price pressures (revaluation).

Obviously, no existing currency area is “optimal” in the sense of this theory because none has ever been determined by equating macroeconomic costs and microeconomic benefits. The renaissance of the OCA theory in the 1980s was all the more remarkable, as two developments in economics had questioned two basic assumptions of OCA theory. First, modern conceptualizations of the exchange rate raised doubts in regards to the effectiveness of the exchange rate as a reliable and effective adjustment instrument. In fact, the occurrence of self-fulfilling currency attacks implied that there was no such thing as an irrevocably [Page 638]fixed exchange rate. Second, the rational expectations revolution in economic methodology suggested that evaluating the various OCA criteria ex ante suffers from a fundamental flaw. The Lucas critique of econometric policy evaluation states that rational economic agents anticipate and respond to policies; their behavior and therefore the “structure” of markets cannot be taken as given. This implies that the OCA criteria will change with monetary integration itself; they are “endogenous” and cannot be evaluated ex ante.

...