Optimum Currency Area
What is Optimum Currency Area?
An optimum currency area is a region where the gains from sharing one currency outweigh the costs of giving up independent monetary policy and exchange-rate adjustment.
Robert Mundell asked when countries should adopt a common currency. Joining yields efficiency gains (lower transaction costs, no exchange-rate risk) but sacrifices the ability to use monetary policy or a flexible exchange rate to absorb country-specific shocks. The area is more 'optimal' when members have high labor mobility, wage and price flexibility, fiscal transfers, and synchronized business cycles, criteria often used to debate the eurozone.
Optimum Currency Area: a worked example
Northland and Southland share one currency and have equally sized workforces. A slump in foreign travel hits Southland hotels, pushing its unemployment from 4% to 11% while Northland stays at 4%. Union-wide unemployment is (4 + 11) / 2 = 7.5%, so the shared central bank sets one rate for a problem of a size that exists in neither place. With its own currency Southland could devalue 12%, cutting the foreign price of a $200 room to $176. Inside the union it has to reach that price by cutting wages and prices 12% instead, so a $25 hourly wage falls to $22. Whether that is bearable depends on how fast workers can move north.
The mistake students make with optimum currency area
The usual mistake is treating heavy trade or shared borders as the test, so any two neighbors that trade a lot should obviously share a currency. Trade volume only raises the benefit side, the transaction costs saved. What decides the question is the cost side: whether shocks hit members at the same time, and whether wages, migration or fiscal transfers can do the adjusting when they do not. Two big trading partners with opposite export mixes can be the worse candidates, and two distant economies whose cycles move together the better ones.
Optimum Currency Area questions
What are the criteria for an optimum currency area?
The optimum currency area criteria are labor mobility between members, flexible wages and prices, a shared fiscal mechanism that can move money toward a struggling member, and business cycles that rise and fall together. Openness to trade among members adds to the benefit side, since it raises how much transaction cost a single currency saves. The more of these a group has, the cheaper it is to surrender monetary policy.
What does a country give up by joining a currency union?
A country joining a currency union gives up two adjustment tools: setting its own interest rate and letting its exchange rate move. If a downturn hits that member alone, the shared central bank sets policy for the average member rather than for it, and no exchange rate falls to make its exports cheaper. Adjustment then has to run through wages, prices, migration or transfers from other members.
Can a single country be an optimum currency area?
A single country is not automatically an optimum currency area, because the same logic applies to regions inside one border. A large economy whose farming region and manufacturing region get hit by opposite shocks faces the identical problem. It copes because workers already move between regions freely and the national budget already shifts money toward the weaker region without anyone having to negotiate a rescue.
Related terms
Common comparisons
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