Optimum currency area
Encyclopedia
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 a certain 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 the euro 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 do not 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 four often cited criteria for a successful currency union are:
While Europe scores well on some of the measures characterising an OCA, it has lower labour mobility than the United States and similarly cannot rely on fiscal federalism
to smooth out regional economic disturbances.
Additional criteria suggested are:
and the European Union
. Despite the prominence of the EU as the primary case study of a OCA, many have argued that the EU does actually not meet the criteria for an OCA.
. He found that five of the eight regions of the country satisfied Mundell's criteria to form an Optimal Currency Area. However, he found the fit of the Southeast and Southwest to be questionable. He also found that the Plains would not fit into an optimal currency area.
Supposing that the currency is managed properly, the larger the area, the better. In contrast with the previous model, asymmetric shocks are not considered to undermine the common currency because of the existence of the common currency. This spreads the shocks in the area because all regions share claims on each other in the same currency and can use them for dumping the shock, while in a flexible exchange rate regime, the cost will be concentrated on the individual regions, since the devaluation will reduce its buying power. So despite a less fine tuned monetary policy the real economy should do better.
Robert A. Mundell is found in both sides of the debate about the euro. Most economists cite preferentially the first (stationary expectations) and conclude against the euro, yet Mundell advocates this one, and concludes in favour of the euro.
and Post-Keynesian economists, who emphasize the role of deficit spending
by a government (formally, fiscal authority) in the running of an economy, and consider using an international currency without fiscal authority to be a loss of "monetary sovereignty".
Specifically, Keynesian economists argue that fiscal stimulus in the form of deficit spending may be necessary to fight unemployment
, which is not possible if states in a monetary union are not allowed to run sufficient deficits.
The Post-Keynesian theory of Neo-Chartalism holds that government deficit spending creates money, that ability to print money is fundamental to a state's ability to command resources, and that "money and monetary policy are intricately linked to political sovereignty and fiscal authority". Both of these critiques consider the transactional benefits of a shared currency to be minor compared to these drawbacks, and more generally place less emphasis on the transactional function of money (a medium of exchange
) and greater emphasis on its use as a unit of account
.
process. This alternative approach seeks to limit deficit spending, as well as to increase the accountability of currency makers to their users in the same way that markets for other goods maximize the accountability of businesses to their customers. Founding Austrian economist Friedrich Hayek
advocated denationalization of money reasoning that private enterprises which issued distinct currencies would have an incentive to maintain their currency’s purchasing power and that customers could choose from among competing offerings. Thus, the Austrian critique of optimal currency areas does not prejudice any particular arrangement so long as it is arrived at by a fair and competitive market process. From "The Failure of OCA Analysis" (The Quarterly Journal of Austrian Economics):
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, 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
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
. The theory is used often to argue whether or not a certain region is ready to become a monetary union, one of the final stages in economic integration
Economic integration
Economic integration refers to trade unification between different states by the partial or full abolishing of customs tariffs on trade taking place within the borders of each state...
.
An optimal currency area is often larger than a country. For instance, part of the rationale behind the creation of the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
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 the euro 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
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, for example, has some regions that do not 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
Robert Mundell
Robert Mundell, CC is a Nobel Prize-winning Canadian economist. Currently, Mundell is a professor of economics at Columbia University and the Chinese University of Hong Kong....
. Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner.
OCA with stationary expectations
Published by Mundell in 1961, this is the most cited by economists. Here asymmetric shocks are considered to undermine the real economy, so if they are too important and cannot be controlled, a regime with floating exchange rates is considered better, because the global monetary policy (interest rates) will not be fine tuned for the particular situation of each constituent region.The four often cited criteria for a successful currency union are:
- Labor mobility across the region. This includes physical ability to travel (visas, workers' rights, etc.), lack of cultural barriers to free movement (such as different languages) and institutional arrangements (such as the ability to have superannuation transferred throughout the region) (Robert A. Mundell).
- Openness with capital mobility and pricePrice-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
and wageWageA wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
flexibility across the region. This is so that the market forcesMarket ForcesMarket Forces is a science fiction novel by Richard Morgan, first published in 2004.Set in 2049 in the wake of a global economic downturn called the Domino Recessions, it follows up-and-coming executive Chris as he plunges into the profitable field of Conflict Investment...
of supply and demandSupply and demandSupply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
automatically distribute money and goods to where they are needed. In practice this does not work perfectly as there is no true wage flexibility. (Ronald McKinnon). The Eurozone members trade heavily with each other (intra-European trade is greater than international trade), and most recent empirical analyses of the 'euro effect' suggest that the single currency has increased trade by 5 to 15 percent in the euro-zone when compared to trade between non-euro countries. - A risk sharing system such as an automatic fiscalFiscalFiscal usually refers to government finance. In this context, it may refer to:* Fiscal deficit, the budget deficit of a government* Fiscal policy, use of government expenditure to influence economic development...
transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics. This usually takes the form of taxation redistribution to less developed areas of a country/region. This policy, though theoretically accepted, is politically difficult to implement as the better-off regions rarely give up their revenue easily. Theoretically, Europe has a no-bailout clause in the Stability and Growth PactStability and Growth PactThe Stability and Growth Pact is an agreement among the 27 Member states of the European Union that take part in the Eurozone, to facilitate and maintain the stability of the Economic and Monetary Union...
, meaning that fiscal transfers are not allowed, but it is impossible to know what will happen in practice. During the 2010 European sovereign debt crisis2010 European sovereign debt crisisFrom late 2009, fears of a sovereign debt crisis developed among investors concerning some European states, intensifying in early 2010 and thereafter.....
, the no-bailout clause was de facto abandoned in April 2010. - Participant countries have similar business cycles. When one country experiences a boom or recession, other countries in the union are likely to follow. This allows the shared central bank to promote growth in downturns and to contain inflation in booms. Should countries in a currency union have idiosyncratic business cycles, then optimal monetary policy may diverge and union participants may be made worse off under a joint central bank.
While Europe scores well on some of the measures characterising an OCA, it has lower labour mobility than the United States and similarly cannot rely on fiscal federalism
Fiscal federalism
As a subfield of public economics, fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government"...
to smooth out regional economic disturbances.
Additional criteria suggested are:
- Production diversification (Peter KenenPeter KenenPeter B. Kenen is a Senior Fellow in International Economics at the Council on Foreign Relations and Walker Professor of Economics and International Finance at Princeton University....
) - Homogeneous preferences
- Commonality of destiny ("Solidarity")
European Union
This theory has been most frequently applied in recent years to the euroEuro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
and the European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
. Despite the prominence of the EU as the primary case study of a OCA, many have argued that the EU does actually not meet the criteria for an OCA.
United States
Kouparitsas considered the United States as divided into the eight regions of the Bureau of Economic AnalysisBureau of Economic Analysis
The Bureau of Economic Analysis is an agency in the United States Department of Commerce that provides important economic statistics including the gross domestic product of the United States. Its stated mission is to "promote a better understanding of the U.S...
. He found that five of the eight regions of the country satisfied Mundell's criteria to form an Optimal Currency Area. However, he found the fit of the Southeast and Southwest to be questionable. He also found that the Plains would not fit into an optimal currency area.
OCA with international risk sharing
Here Mundell tries to model how exchange rate uncertainty will interfere with the economy; this model is less often cited (publication in 1973).Supposing that the currency is managed properly, the larger the area, the better. In contrast with the previous model, asymmetric shocks are not considered to undermine the common currency because of the existence of the common currency. This spreads the shocks in the area because all regions share claims on each other in the same currency and can use them for dumping the shock, while in a flexible exchange rate regime, the cost will be concentrated on the individual regions, since the devaluation will reduce its buying power. So despite a less fine tuned monetary policy the real economy should do better.
Robert A. Mundell is found in both sides of the debate about the euro. Most economists cite preferentially the first (stationary expectations) and conclude against the euro, yet Mundell advocates this one, and concludes in favour of the euro.
Keynesian
The notion of a currency that does not accord with a state, specifically one larger than a state – formally, of an international monetary authority without a corresponding fiscal authority – has been criticized by KeynesianKeynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
and Post-Keynesian economists, who emphasize the role of deficit spending
Deficit spending
Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....
by a government (formally, fiscal authority) in the running of an economy, and consider using an international currency without fiscal authority to be a loss of "monetary sovereignty".
Specifically, Keynesian economists argue that fiscal stimulus in the form of deficit spending may be necessary to fight unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...
, which is not possible if states in a monetary union are not allowed to run sufficient deficits.
The Post-Keynesian theory of Neo-Chartalism holds that government deficit spending creates money, that ability to print money is fundamental to a state's ability to command resources, and that "money and monetary policy are intricately linked to political sovereignty and fiscal authority". Both of these critiques consider the transactional benefits of a shared currency to be minor compared to these drawbacks, and more generally place less emphasis on the transactional function of money (a medium of exchange
Medium of exchange
A medium of exchange is an intermediary used in trade to avoid the inconveniences of a pure barter system.By contrast, as William Stanley Jevons argued, in a barter system there must be a coincidence of wants before two people can trade – one must want exactly what the other has to offer, when and...
) and greater emphasis on its use as a unit of account
Unit of account
A unit of account is a standard monetary unit of measurement of value/cost of goods, services, or assets. It is one of three well-known functions of money. It lends meaning to profits, losses, liability, or assets....
.
Austrian
Offering a contrary criticism, Austrian economists have supported the disassociation of currencies from political entities entirely. Whereas Keynesians see flaws in supranational currencies, Austrians see flaws in any centrally planned currency not determined by a free marketFree market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...
process. This alternative approach seeks to limit deficit spending, as well as to increase the accountability of currency makers to their users in the same way that markets for other goods maximize the accountability of businesses to their customers. Founding Austrian economist Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
advocated denationalization of money reasoning that private enterprises which issued distinct currencies would have an incentive to maintain their currency’s purchasing power and that customers could choose from among competing offerings. Thus, the Austrian critique of optimal currency areas does not prejudice any particular arrangement so long as it is arrived at by a fair and competitive market process. From "The Failure of OCA Analysis" (The Quarterly Journal of Austrian Economics):