A THEORY OF OPTIMUM CURRENCY AREAS MUNDELL PDF

In economics, an optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. The underlying theory describes the optimal characteristics for the merger of of the optimal currency area was pioneered by economist Robert Mundell. The theory of optimum currency areas (OCA) explores the criteria as well as first time that someone used the phrase optimum currency area was Mundell. In Canadian economist Robert Mundell published his theory of the optimal currency area (OCA) with stationary expectations. He outlined.

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This Canadian economist has strong ties in Europe: Robert Mundell og the theoretical foundations for the European Monetary Union. His theory of optimum currency areas, highlighted in the Nobel Committee’s citation as one of his most significant scientific contributions, has served since the s as an analytical framework for numerous debates on the validity of the creation of a European currency.

Mundell was an ardent supporter of the euro, of which he is considered the godfather.

Paradoxically, his theory has been used by numerous economists to oppose the European Monetary Union and question its chances of success. How can one be the author of a theory that criticizes the monetary union and one of the principal spiritual fathers of the euro at the same time?

The paradox is merely an illusion, as I will try to explain. The question is innovative, for Mundell envisaged a new global monetary map from the regional rather than the national viewpoint.

Hence, a region of Germany could join with a region of France to create their own currency and abandon the mark and the franc. Mundell takes the example of North America.

In what circumstances could it be of benefit for Western Canada and the Western United States to join together to create a Western currency, or for the Eastern parts of the two countries to create a currency peculiar to the East of the continent?

The relationship between these two new currencies, which would replace the Canadian dollar and the United States dollar, would be governed by a floating exchange rate.

To respond to this question, Mundell develops a cost-benefit analysis of the monetary union. The benefits of adopting a common currency include a reduction of the various transaction costs generated by the existence of various currencies and a gain in the liquidity of the currency, attributable mainly to the expansion of its area of transactions, from which all financial markets would also benefit.

The potential disadvantages would come from the elimination of the exchange rate between participants in the union: To understand the notion of asymmetrical shock and the role of the exchange rate, let us assume with Mundell that Western Canada produces forestry products, and the East, automobiles.

Optimum currency area

Let us imagine a change in consumer tastes that pushes up the demand for automobiles and compresses that for forestry products. This shock is asymmetrical to the extent that it creates a surplus currenc for products from the East and a surplus supply of products from the West.

The price of automobiles will tend to increase, leading to a general rise in prices in the East; conversely, prices will tend to decline in the West, as a result of a fall in the price of forestry products.

The terms of trade between the West and the East deteriorate. In this example, if the two regions use the same currency, the Canadian dollar, the Canadian central bank will be faced with a dilemma: This dilemma can be resolved through mobility of the factors of production, and the labor factor in particular. If capital and labor shift from the industries that have suffered from a decline in demand toward those enjoying surplus demand, from the West toward the East in our example, balance can be restored in the arezs of prices and employment.

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Robert Mundell and the Theoretical Foundation for the European Monetary Union

Where there is no mobility in the factors of production, asymmetrical shocks could be absorbed by a change in the exchange rate, but for that to occur, the affected regions must each have their own currency. In the previous example, if there were currenvy central bank in the West, it could lower its interest rates to combat unemployment, while the central bank in the East could raise its interest rates to combat inflation. The Western currency would depreciate against that of the East, and balance would be restored at a lower adjustment cost than if the two regions had had a common currency.

This analysis highlights a number of criteria that a monetary union must meet. At the top of the list is an absence of frequent, large-scale asymmetrical shocks and mobility in the factors of production.

To these two criteria, the following must be added: The more open the economy, the more sensitive it will be to shocks and the less stable and liquid its currency will be. It follows that for an open, diversified economy, the benefits of joining a monetary union in terms of gains in liquidity and financial stability can offset the additional adjustment costs that could result from its joining the union. These considerations dominated scientific debate on the European Monetary Union, with most analysts concluding that Europe, whether made up of six, eleven, or fifteen countries, did not constitute an optimum currency area, as it met the above-mentioned criteria only partially.

On the one hand, optimum currency areas would, in any case, almost never fit into the confines of a state or a collection of existing states. For a currency area to be optimal strictly speaking, it must nearly always be necessary for various regions of a single state to join with different monetary areas, each having its own currency. This implies that any proposal of a union of existing states could be rejected on grounds of nonoptimality, if the term optimality is to be given its strict meaning.

On the other hand, the labor markets in the principal European countries suffer from keen rigidities. The labor factor, which already has little mobility within certain countries, is even less mobile in the region as a whole. As a supporter of the euro, Mundell can respond in several ways to those for whom his theory of optimum currency areas condemns the European Monetary Union to failure. First, the argument that floating exchange arrangements are superior to fixed exchange arrangements or to a common currency for mitigating the effects of asymmetrical shocks is based, as Mundell’s article explicitly points out, on the existence of money illusion.

Economic agents suffer from money illusion if they are ready to agree to a drop in their real wages provided that this is achieved through a rise in prices that leaves their nominal wages unchanged, but not if it is achieved through a decline in their nominal wages.

In our Canadian example, the depreciation of the Western currency leads to a rise in import prices and in price levels generally, thus offsetting the effect of the decline in demand for forestry products produced in the region. If workers agree to a drop in their real wages through a theor in prices caused by devaluation, it will be possible to maintain employment.

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For Mundell, money illusion of this type cannot be expected to last for very long. Mundel, for a small country or for a region where the share of imports and exports in GDP is large, the effects of a devaluation on price levels will be immediate, and the money illusion will quickly disappear.

Moreover, if a country systematically uses the depreciation currench its domestic currency to stimulate employment, wages will soon be adjusted, and the stimulating effect will disappear, to be followed by inflation. In the circumstances, the main argument for exchange flexibility is the possibility theort the necessity of adopting an exchange rate different from that of the rest of the world.

The possibility of adopting a more moderate inflation rate if the rest of the world is unstable and the country in question is stable; the necessity of adopting a higher inflation rate if the country is incapable of managing its fiscal and monetary policy in a stable manner.

Second, within a single country, capital mobility can take the place of labor mobility in facilitating adjustment. And the monetary union itself is a factor of integration which will at the same time increase the mobility of the factors of production and reduce the probability of asymmetrical shocks. Third, the benefits of a common currency and its integrating effect on other markets, especially financial markets, are often underestimated, or ignored, by “economists” using Mundell’s study to attack the European Monetary Union.

Our Nobel prize winner was therefore being neither inconsistent nor schizophrenic when he supported the idea of a monetary union in Europe in the s. What is important is to give up credibly the idea of having an autonomous national monetary policy and to establish the institutions necessary for the management of a common monetary policy.

Beyond the primarily economic and technical considerations, Mundell’s concern was also to place the creation of the euro in a broader perspective, that of the international monetary system, whose operations he analyzed, perhaps better than anyone else, in his work. The European Monetary Union is an eminently political instrument that can be understood only in light of historical developments in the old continent. It is symptomatic of an erosion of the hegemony of the United States and represents a counterbalance to the dollar, even if the latter remains the dominant currency.

For Mundell, the existence of a stable monetary anchor is essential. That explains his penchant for monetary systems in which, without going so far as to return to the gold standard, currencies continue to be pegged in one way or another to a precious metal. That also explains why he saw an increasing number of countries gravitating toward the two major currencies of the 21st century, the dollar and the euro.

Login or Register Information of interest. In normal usage, monetarists are supporters of the rules requiring growth of the monetary aggregates and floating exchange arrangements. Monetarists in the normal sense of the term are therefore “economists” in the sense of the debate on the monetary union! Views and Commentaries for