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Optimum Currency Area (OCA) Theory

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Published: Tue, 12 Dec 2017

What criteria did Mundell use to identify an optimum currency area and how relevant are these criteria today in deciding whether two countries constitute an optimum currency area?

An Optimum Currency Area (OCA) is a geographical region in which maximise economic efficiency is attained by the entire region sharing a single currency (a monetary union), or by several currencies pegging to each other via a fixed exchange rate. National authorities have come to the realisation that by merging with other countries to share a currency, everyone might benefit from gains in economic efficiency. An example of this can be seen in the formation of the euro where the countries involved do not individually match the criteria of an OCA, but believe that together they come close. The aim of national authorities is to establish the correct form of economic integration to maximise efficiency.

One of the original founders of the OCA theory was economist Robert Mundell. In his first paper ‘A Theory of Optimum Currency Areas’ (1961) he presented several principal criteria to create a functioning monetary union. To support these criteria for an OCA I shall on occasion refer to an example of consumer preferences switching from French to German-made products by Paul De Grauwe (2003). The change in consumer preferences will cause an upward shift in aggregate demand in Germany and a downward shift in France as shown in 1 below. The output decline in France and increase in Germany is most likely to cause unemployment to increase in France but decrease in Germany.

The first of the criteria for an OCA is price and wage flexibility throughout the geographical area. This means that the market forces of supply and demand automatically distribute money and goods to where they are needed. For example, with regards to France and Germany under perfect wage flexibility, the unemployed workers in France will reduce their wage claims, and conversely excess demand for labour in Germany will push up the wage rate. This inevitably shifts aggregate supply for France outwards making French products more competitive, and stimulating demand, whereas the opposite occurs for Germany. 2 below shows the effect of wage flexibility as an automatic adjustment mechanism.

Mundell cited the importance of factor mobility as an “essential ingredient of a common currency” (Mundell, 1961) and thus labour mobility across the geographical region is one of Mundell’s main criteria for an OCA. In the case of De Grauwe’s example, French unemployed workers would move to Germany where there is excess demand for labour. This free movement of labour eliminates the need to let wages decline in France and increase in Germany solving both the unemployment problem in France, and the inflationary wage pressures in Germany.

The existence of labour mobility relies on the unrealistic assumptions of free movement of workers between regions regardless of physical barriers such as work permits, cultural barriers such as language difficulties and institutional barriers such as superannuation transferrals. Indeed Peter Kenen referred to the additional costs of retraining workers and there is an “unrealistic assumption of perfect occupational mobility“(Kenen, 1969). Ronald McKinnon observed that “in practice this does not work perfectly as there is no true wage flexibility” (McKinnon, 1979). McKinnon is simply highlighting the point that in reality wage flexibility, as well as perfect labour and capital mobility do not always exist. Considering a case where wages in France do not decline despite the unemployment situation (no wage flexibility), and French workers do not move to Germany (no labour mobility) both Germany and France would be stuck in the original position of disequilibrium. In Germany the excess demand for labour would put pressure on the wage rate, causing an upward shift in the supply curve. The adjustment from the position of disequilibrium would in this case come exclusively from price increases in Germany making French goods more competitive once more. Therefore if wage flexibility and labour mobility does not exist then the adjustment process will be entirely reliant on inflation in Germany.

Mundell stated product diversification over the geographical area is an important determinant of the suitability for a region to share a currency. This has been supported by many economists, such as Peter Kenen who says “groups of countries with diversified domestic production are more likely to constitute optimum currency areas than groups whose members are highly specialised” (Kenen, 1969). Finally Mundell stated that an automatic fiscal transfer mechanism is required to redistribute money to sectors with adverse affects from labour and capital mobility. This usually takes the form of taxation redistribution to less developed areas of the OCA. Whilst this is theoretically ideal and necessary, in practice it is extremely difficult to get the well off regions of the OCA to give away their wealth.

Mundell produced two models in relation to OCA theory. In the first, under a model of Stationary Expectations (SE), he takes a pessimistic view towards monetary integration, however in his second paper he counters this, and focuses on the benefits of a monetary union under the model of International Risk Sharing (IRS), which has conversely been used to argue for the forming of monetary unions.

‘The Theory of Optimal Currency Areas’ paper by Mundell in 1961 portrays OCAs under stationary expectations. The assumption is made that asymmetric shocks undermine the real economy and thus flexible exchange rates are considered preferable because a shared monetary policy would not be precisely tuned for the specific situation of each constituent region. This paper led to the formation of the Mundell-Fleming Model of an open economy which has been used to argue against the forming of monetary unions as an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy.

Whilst the Mundell’s criteria for an OCA is held in high regard my many economists, there are some criticisms levelled at him. Capital mobility is seen to have been a “greater adjustment mechanism than labour mobility” (Eichengreen, 1990) and this is a factor John Ingram criticises Mundell for ignoring. Clearly the openness of the region to capital mobility is crucial to the makeup of an OCA, as for trade to exist between participating regions, free movement of capital is necessary.

However in the years that followed his 1961 paper on OCAs Mundell realised the criticisms of his previous paper and began to doubt the basic argument for flexible exchange rates as an adjustment mechanism. He became more appreciative of the adjustment mechanism under fixed exchange rates, “It was not that I had forgotten the Mundell-Fleming model, but that I had gone beyond it” (Mundell, 1997). In Mundell’s 1973 paper, ‘Uncommon Arguments for Common Currencies’, he discarded his earlier assumption of static expectations to look at how future uncertainty about the exchange rate could disrupt the capital markets by restraining international portfolio diversification and risk-sharing. Here he introduces his second model of OCAs under IRS. He counters his previous idea that asymmetric shocks weaken the case for a common currency by suggesting that a common currency can reduce such shocks by sharing the burden of loss. He uses the example of two countries, Capricorn and Cancer. In spring, Cancer ships half of its crop to Capricorn and in return it receives evidence of Capricorn’s debt, a claim to half of Capricorns food crop in autumn. While one country is expanding its money supply and running a balance of payments surplus, the other will be running a balance of payments deficit, and the process is reversed during the next period.

Mundell points out that this system is very satisfactory in a world of certainty, however in reality there is speculation about the convertibility of foreign currencies. If Cancer had a bad harvest and produced less crop, to redeem all of notes from the Capricorn would involve providing them with their promised share of crop as usual, leaving Cancer short. The only defence against paying out the promised share of crop would be a devaluation of Cancer’s currency and thus a reduction in the claim by Capricorn on the crop. Capricorn needs to get enough crops to survive and produce food in the autumn, so Cancer will not also be left short on supplies in the next period. The solution would appear to be a partial devaluation of Cancers currency, so that the burden of loss would be shared between the two countries.

Mundell has shown that with different currencies comes the uncertainty of devaluation, a problem which a common currency would not have. Under a common “world” currency if Cancer has a bad crop the total amount of world currency will exchange for full quantity of crop, irrespective of who holds the money as competition and freedom of arbitrage assures a single price. So long as competition exists, and there are no time lags in the transmission of goods or information, the price of the food will rise for both countries and so the burden of shock is shared automatically and equally by the two countries.

To reconcile Mundell’s two papers and assess the appropriateness the criteria on determining two countries suitability as a currency area I have decided to look at the case of the European Monetary Union (EMU) and its success as a monetary union.

There are many examples of countries within Europe that would struggle to maintain international competitiveness without the currency area. The areas of the EU with low labour mobility are furthest away from meeting the criteria of a currency area. However, while the removal of legal barriers (such as visas) has improved this labour mobility, issues such as language barriers remain, for example, a French worker may not wish to move to Spain because they cannot speak Spanish, also people tend to have ties to the places they currently live and may not be willing to move away from them. Bayoumi and Eichengreen (1992) compared the US and Europe with respect to how disturbances in separate regions match shocks in a selected benchmark region. They chose Germany as the benchmark for Europe and found that there is a relatively high symmetry of disturbances within the core of the EU such as Austria, Benelux, Denmark, France and Germany. They also found that the symmetry was lower for western European countries. When compared to the USA, the EMU had a higher probability of asymmetric shocks. However according to Fidrmuc and Korhonen (2001) the extent of the asymmetric shocks is declining in the EU economies. Bayoumi and Eichengreen believe that countries within Europe are further from an OCA than regions in the USA, and so are less appropriate as a currency area. These studies suggest that two countries in the EU are less suited to forming a monetary union than the regions of the USA, although the situation is improving. Frankel and Rose (1998) argued that the higher the trade integration, the higher the correlation of the business cycles among countries, in other words there is greater symmetry of shocks. They also propose that business cycles and trade integration are inter-related and endogenous processes to establishing a currency union. Frankel and Rose’s empirical findings noted that EMU entry encourages trade linkages among countries and causes the business cycle to be more symmetrical among the union’s participants. Rose and Stanley (2005) find that a common currency generally increases trade among its members between 30% and 90%. These findings agree with Mundell’s argument that a common currency can help to deal with asymmetrical shocks. Frankel and Rose’s findings suggest that although two countries considering creating a common currency may not meet the criteria before they join the currency area they may do afterwards.

Economists are divided in opinion between Mundell’s two OCA models. The contrasting views which Mundell presents in his papers have earned him a title as “the intellectual father to both sides of the debate”. While some economists support the theory of stationary expectations, preferring flexible exchange rates, and conclude against the euro, others advocate the IRS model, preferring the fixed exchange rate, and conclude in favour of the euro. Mundell himself seems to have eventually settled in favour fixed exchange rates in a monetary union however he does still advocate the use of flexible exchange rates in two cases. In the case of unstable countries, whose inflation differs significant from its currency sharing regions and in large countries where there is no established international monetary system, e.g. the USA. From Mundell’s studies I can conclude that two countries which are heavily integrated through highly mobile factors of production which are highly diversified in their goods should join a common currency. With regard to the relevance of Mundell’s theory today I would say his studies are still valid and used heavily as complementary theory to monetary integration occurring in Europe and throughout the world.

References

Robert Mundell

‘A Theory of Optimum Currency Areas’, 1961

‘Uncommon Arguments for Common Currencies’ p. 115, 1973

A Conference on Optimum Currency Areas at Tel-Aviv University, 5th December 1997

Paul De Grauwe

‘Economics of Monetary Union’ p. 7, 2003)

Robert McKinnon

‘Money in International Exchange: The Convertible Currency System’, 1979

Peter Kenen

‘The theory of Optimum Currency Areas: an Eclectic view‘, 1969

‘Monetary Problems of the International Economy’, 1969, pp. 95-100

Barry Eichengreen

‘One Money for Europe? Lessons from the US Currency Union’, 1990

‘Is Europe an Optimal Currency Area’, 1991

J. Fidrmuc & I. Korhonen

‘Similarity of supply and demand shocks between the Euro area and the CEECs’, 2001

J. A. Frankel & A. K. Rose

‘The Endogeneity of the Optimum Currency Area Criteria’ pp. 1009-25, Jul 1998

A. K. Rose & T. D. Stanley

‘A Meta-Analysis of the Effect of Common Currencies on International Trade’, pp 347-365, 2005


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