Currency area

Optimum Currency Area

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. It describes the optimal characteristics for the merger of currencies or the creation of a new currency. The theory is used often to argue whether or not acertain region is ready to become a monetary union, one of the final stages in economic integration.

An optimal currency area is often larger than a country. For instance, part of the rationale behind the creation of the euro is that the individual countries of Europe do not each form an optimal currency area, but that Europe as a whole does form an optimal currency area. The creation of theeuro is often cited because it provides the most modern and largest-scale case study of the engineering of an optimum currency area, and provides a comparative before-and-after model by which to test the principles of the theory.

In theory, an optimal currency area could also be smaller than a country. Some economists have argued that the United States, for example, has some regions that donot fit into an optimal currency area with the rest of the country.

The theory of the optimal currency area was pioneered by economist Robert Mundell. Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner.

The theory of optimum currency areas argues that the optimal area for a system of fixed exchange rates, or a commoncurrency, is one that is highly economically integrated.

* Economic integration means free flows of
* Goods and services (trade)
* Financial capital and physical capital
* Workers/labor (immigration and emigration)

Currency Areas and Common Currencies

A single currency implies a single central bank (with note-issuing powers) and therefore a potentially elasticsupply of interregional means of payments. But in a currency area comprising more than one currency, the supply of international means of payment is conditional upon the cooperation of many central banks; no central bank can expand its own liabilities much faster than other central banks without losing reserves and impairing convertibility. This means that there will be a major difference betweenadjustment within a currency area that has a single currency and a currency area involving more than one currency; in other words, there will be a difference between interregional adjustment and international adjustment even though exchange rates in the latter case are fixed.

To illustrate this difference, consider a simple model of two entities (regions or countries), initially in fullemployment and balance-of-payments equilibrium, and see what happens when this equilibrium is disturbed by a shift of demand from the goods of entity B to the goods of entity A. Assume that money wages and prices cannot be reduced in the short run without causing unemployment, and that monetary authorities act to prevent inflation.

Suppose first that the entities are countries with nationalcurrencies. The shift of demand from B to A causes unemployment in B and inflationary pressure in A. To the extent that prices are allowed to rise in A, the change in the terms of trade will relieve B of some of the burden of adjustment. But, if A tightens credit restrictions to prevent prices from rising, all the burden of adjustment is thrust onto country B; what is needed is a reduction in B's realincome, and if this cannot be effected by a change in the terms of trade- because B cannot lower, and A will not raise, prices-it must be accomplished by a decline in B's output and employment. The policy of surplus countries in restraining prices therefore imparts a recessive tendency to the world economy on fixed exchange rates or (more generally) to a currency area with many separate currencies....