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Theory of optimum currency areas
 
Definition:
a group of economic entities (individuals, regions, nations) among which welfare is
maximised through fixed exchange rates (or a common currency) and a flexible
exchange rate towards the rest of the world.
The notion of „optimum currency areas? was coined by Mundell in 1961 who defined optimality „in
terms of ability to stabilise national employment and price levels?. He proceeds to define an
economic region as an optimal currency area when it exhibits characteristics that lead to an automatic
removal of unemployment and payments disequilibria; automatic in the sense that no interference is
required from monetary and fiscal policies to restore equilibrium. The conclusion given is that a
currency area should be formed in that  economic region where such costs can be minimised, the
implication being that the maximum net benefits of a currency area would then be accomplished. 
 
Optimal currency area theory therefore concentrates upon defining those characteristics (i.e.
preconditions) which have been identified as relevant for choosing the likely participants in an
optimum currency area. The following is a list of recognised characteristics:
(i)
similarity of inflation rates - if relative prices rise faster in one country than another, it will
become increasingly uncompetitive unless it can reduce wages and prices back to the norm.
Consequently, a persistently higher propensity to inflation within one country will result in
unemployment, concentrated within depressed areas, in the absence of devaluation or
compensatory price changes.
(ii) the degree of factor mobility - if wages and prices are sticky, and devaluation is not an option,
an uncompetitive position for an individual country can be reconciled if factor mobility is high. 
(iii) price and wage flexibility - the transition toward adjustment within a currency union is less
likely to be associated with unemployment in one region and inflation in another. This largely
restates (ii) except for the fact that the former relates to physical movement of resources whilst
this condition concerns the movement of the price of those resources.
(iv) degree of commodity diversification - highly diversified economies will respond better to
currency union than less diversified economies since they provided greater insulation against a
variety of external shocks.
(v) degree of goods market integration - countries that possess similar production structures are#p#分頁標題#e#
more prone to symmetric (as opposed to asymmetric) shocks, thereby lessening the importance
 
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of exchange rate variations to correct imbalances in competitiveness caused by the external
environment.
(vi) openness and size of the economy - relates to the proportion of GDP traded between
participating nations, rather than in general. The higher this proportion, the lower the
anticipated cost of participating in a currency area. This idea is expressed in Figure 1.
 
Benefits
Costs
Trade share of GDP
% of GDP
T
0
Benefits and costs as trade share varies between two countries in monetary union
If trade share
exceeds T , EMU
net benefit
If trade share is
less than T , EMU
net cost
 http://www.400190.com/Thesis_Writing/Economics/2012/0601/2058.html
(vii) fiscal integration and inter-regional transfers - the higher the degree of fiscal harmonisation
between areas participating in a currency union, the greater the ability to smooth out diverse
shocks and differential inflation rates through transfers to the unemployed, together with active
regional policy to attract enterprises to the depressed areas. Thus, the social, structural and
cohesion funds operated by the EU are intended to perform a similar role, however, the central
budget would have to be much larger to perform this task within a currency union - rising from
its present 1.2% of EU GDP to at least 20-25% of GDP (the average amongst federations) or
approximately 45% (average for industrialised nation states).
(viii) political factors - perhaps the decisive factor, despite the economic arguments outlined above,
is whether the political will exists to pursue monetary integration amongst all prospective
participants.
 
Mundell sought to define the perfect economic region for a currency area. The result is that the
formation of an optimal currency area would involve a redefinition of frontiers in that the area may
not conform to national boundaries. This is clearly a less realistic approach than that which seeks to
determine whether or not a given group of countries should form a currency area or an exchange rate
union, but it does, nevertheless, provide a basis for empirical study of the EU. Three conclusions
follow from this analysis:
? OCA?s tend to be smaller than optimal areas for fixed exchange rates
? OCA theory might suggest that monetary union may be rational amongst certain EU member
states whilst irrational for others
? frontiers in an OCA may not conform to national boundaries but consist of certain regions
from several countries, but not others
 
4.
Origins of EMU#p#分頁標題#e#
 
The immediate impulse that led to the relaunch of EMU in the late 1980s was in the prospect of the
completion of the Single Market. The Heads of State and Governments stated at the European
Council meeting in Hanover in 1988 that „in adopting the Single Act, the Member States of the
Community confirmed the objective of progressive realization of economic and monetary union?. It
was decided to set up a committee to study and propose „concrete stages leading towards this union?
to be on the agenda at the 1989 summit in Madrid. 
 
3
 
The Delors Report outlined three stages that would lead to the creation of an area with complete
freedom of movement for persons, goods, services and capital, as well as irrevocably fixed exchange
rates between national currencies and, finally, a single currency. These became the basis of the TEU
whereby monetary union was to be achieved in three stages. In Stage 1, which began in 1990, any
remaining capital controls were abolished, the UK was encouraged to join the ERM (which it did in
1990, only to leave in 1992) and exchange rate realignments were possible, but discouraged. In Stage
2, which began in January 1994, a new European Monetary Institute (EMI) prepared the ground for
EMU, realignments within the ERM were even harder to obtain and excessive national budget
deficits were to be discouraged, but not outlawed. Stage 3, in which exchange rates were irreversibly
fixed and the single monetary policy began, was scheduled to start in 1997 if a majority of potential
entrants fulfilled the Maastricht convergence criteria. In the event, the Madrid European Council of
December 1995 decided the Stage 3 would commence on 1 January 1999.
 
 
5. The Maastricht Treaty and EMU
6.   Costs and Benefits of EMU
7. EMU and the world economy
8.   Appraisal

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