The Theory of Optimal Currency Areas

Robert Mundell’s (1961) Theory of Optimal Currency Areas examines the conditions that economic regions should satisfy in order for them to form a monetary union.  The theory is as follows.

Assume the existence of two economic regions A and B (these economic regions may be, for example, two different nation-states or two different regions within the same nation-state). Assume that region A produces a single economic good and region B produces a different economic good. Now suppose that a change in consumer preferences causes a shift in demand from the good produced in region A to the good produced in region B. That is, suppose that an asymmetric shock occurs which causes a decrease in the demand for the good produced in region A and an increase in demand for the good produced in region B. [1] This asymmetric shock will cause an increase in region A’s unemployment and result in a trade imbalance in which region A imports more from region B than it exports to region B. Moreover, the increased demand for region B’s good will cause an increase in inflationary pressures in region B. The effects of this asymmetric shock are represented in the figure below.

Now suppose that each region issues its own regional currency and that the exchange rates between the two regional currencies are flexible. The increased demand for region B’s good by consumers in region A will result in selling of region A’s currency in order to purchase region B’s currency. In a world with flexible exchange rates, this will result in a depreciation of region A's currency relative to region B's currency (and symmetrically, it causes an appreciation of region B's currency relative to region A's currency). The depreciation of region A’s currency will reduce the price of its good for consumers in region B, thus increasing demand for region A’s product, and so, alleviating region A’s increased unemployment. And the appreciation of region B’s currency will alleviate the inflationary pressures in region B by increasing the cost of region B’s economic good for consumers in region A, thereby reducing demand for region B’s good. Thus, in the case where each economic region issues its own currency and the exchange rates between them are flexible, the change in the exchange rate between the two region’s currencies following an asymmetric shock allows for the re-establishment of equilibrium (see figure 2). In the case of fixed exchange rates, the same effects can be achieved by the devaluation of region A’s currency relative to region B’s currency.

Now suppose that these two economic regions are members of a monetary union and so, by definition, share a common monetary policy. The shared monetary policy of these two regions is incapable of simultaneously resolving the problems in both regions. To see this, suppose that the common central bank tightens monetary policy (see figure 3 below). This tightening would reduce the inflationary pressures in region B. However, it would also exacerbate the unemployment problem in region A. Suppose instead that the common central bank eases monetary policy (see figure 4 below). This easing would reduce unemployment in region A. However, it would also exacerbate the inflation problem in region B.

Given the ineffectiveness of monetary policy in this scenario, an alternative adjustment mechanism will be required in order to address the disequilibrium caused by the asymmetric shock. If the two regions each had their own currency, the disequilibrium could be resolved by a depreciation or devaluation of the exchange rate of region A relative to region B. However, in a monetary union with a single currency, this is not possible. Thus, equilibrium must be restored by some other means. Three possible alternatives exist. One possibility is a decline in nominal wages and prices (i.e. deflation) in region A. This would reduce the price of region A’s good for consumers in region B, thus increasing demand for region A’s good, and so, alleviating region A’s unemployment (see figure 5). Another possibility is migration of unemployed laborers out of region A and into region B. This would alleviate region A’s unemployment problem and increase the supply of labor in region B in order to facilitate the increased production of region B’s good (see figure 6). A third possibility is to set up a system of fiscal transfers from a centralized union budget which provides insurance against asymmetric shocks. When an economic region is hit by a negative economic shock, the centralized union budget will automatically transfer income from member states experiencing better economic conditions, and therefore paying a greater amount into the union budget, to member states experiencing worse economic conditions who receive unemployment insurance from the union budget.

Thus, in order to determine whether two (or more) economic regions are candidates to form a monetary union, OCA theory first asks whether these economic regions frequently experience asymmetric shocks. If they do not frequently experience asymmetric shocks (i.e. growth rates of output and unemployment between the economic regions are sufficiently correlated) the region is a candidate to form a monetary union. If the regions do frequently experience asymmetric macroeconomic shocks, OCA theory then requires that both economic regions have downwardly flexible wages, free movement of labor, and a fiscal union so that they may adjust to these shocks.

So far, we have only looked at the costs of forming a monetary union. However, in deciding whether a group of economic regions are candidates to form a monetary union, OCA theory also considers the prospective benefits. The first benefit is reduced transactions costs: sharing a common currency with trading partners eliminates the cost of exchanging currencies in order to conduct trade. The second benefit is the reduced uncertainty about relative prices between an economic region and its trading partners that comes from eliminating exchange rate volatility. Note that the extent of both of these benefits grows as the degree of openness between the economic regions increases (i.e. the more trade the economic regions conduct with each other, the greater the reduction in transaction costs and the more significant the effect of reduced exchange rate uncertainty). Thus, another condition OCA theory suggests regions should satisfy in order to form a monetary union is that they should have a sufficient degree of trade integration with the other members of the union, so as to generate benefits from using a common currency.

In sum, the OCA theory amounts to a cost-benefit analysis for monetary unions. The costs come from the potential occurrence of and inability to adjust to asymmetric macroeconomic shocks. The benefits come from reduced transactions costs and reduced uncertainty about exchange rates. For OCA theory, the relative balance of these costs and benefits determines whether economic regions are potential candidates to form a monetary union. 

Written By: Aiden Singh Published: December 9, 2019.

Footnotes

[1] Note that asymmetric shocks can take many different forms: they may be real or financial, temporary or permanent, exogenous or policy-induced, and country-specific or sector specific (European Parliament, 1998).

Sources

European Parliament. Adjustment to Asymmetric Shocks. 1998.

Robert Mundell. A Theory of Optimum Currency Areas. The American Economic Review. Vol. 51, No. 4. Pg. 657-665. September, 1961