Preconditions to Be an Optimum Currency Area

Several criteria for an OCA have been advanced. Three well-known classic economic criteria are the labour mobility criterion (proposed by Robert Mundell), the openness criterion (proposed by Ronald McKinnon) and production diversification criterion (proposed by Peter Kenen)

The labour mobility criterion looks at the way of minimizing the costs of sharing the same currency within a currency area in terms of less unemployment. The idea is that the cost of sharing the same currency would be eliminated if the factors of production, capital and labour were fully mobile across borders. If, for instance, country A is booming, while country B suffers from weak demand and unemployment, and if labour can move from B to A fairly easily, the regional imbalance can be corrected without a need for country B to adopt fiscal and/or monetary policies, and perhaps accept inflation, to expand demand. Since it is conventionally assumed that (financial) capital is mobile (in particular since the deregulation and liberalisation of the capital markets during the 1980s), the real hurdle comes from the lack of labour mobility which is caused by several factors. Firstly, across borders, not only do cultural and linguistic differences restrain migration, but institutional barriers further discourage labour mobility (e.g. labour market regulations and traditions, differences in welfare system between members and the ability to strike agreements between firms, trade unions and governments etc.). Changes in legislation may make cross-border labour mobility easier and enlarge the size of an OCA. Secondly, the goods produced in country A may differ from those produced in country B, which may take some time to retrain workers (e.g. the cheese produced in Italy is different from the Netherlands). Thirdly, labour needs equipment to be productive. Although financial capital can move freely and quickly (in the EU there are no exchange controls anymore), installed physical capital (means of production such as plants and equipment) is not mobile. It takes time to build plants and shift the location of economic activities. The Mundell criterion thus focuses on labour's market willingness to move in response to asymmetric shocks. Labour mobility is not a panacea, but just one of the many factors that mitigate the costs of an asymmetric shock in the currency area.

More labour mobility within an OCA can also have adverse effects when it causes a region with low productivity to experience a rapid rise in wages because unemployment has caused the skilled workers to leave. Since the German reunification in 1990 the move of workers from eastern to western Germany is a case in point. The EU enlargement in 2004 is another example of an event which caused many eastern (e.g. Polish) workers to search for better job opportunities in western Europe. Labour mobility is not always an appropriate solution for temporary disturbances in the demand for labour because the cost of moving are considerable and this might threaten the 'catching up' process of economic weaker member states of the EMU. Different from the US and Canada, the current EMU, cannot be qualified as an OCA on the criterion of labour mobility due to rigidities on the labour market, cultural and linguistic difficulties. Differences in unemployment are not fully reflected in differences in real wages (i.e. nominal wages adjusted for the price level). This means that asymmetric shocks, when they occur, are likely to be met by unemployment in countries facing a loss of competitiveness.

Ronald McKinnon emphasises that when the economy of a country is small and very open to trade, it has little ability to change the prices of its goods on the international markets. In that situation, giving up the exchange rate as a tool to adjust the competitiveness does not entail a serious loss of policy independence. Relatively small and open economies, with a high degree of interdependence with other countries, can benefit the most from expanding demand in a neighbouring country and form relatively easily an OCA. Examples in the EU are Belgium, Denmark, Ireland and the Netherlands with very high exposure to the outside world measured in terms of exports and imports as a percentage of GDP. These countries have a relatively high export versus import ratio are very dependent upon trade and as such are very vulnerable when the business cycle of their trading partners deteriorates. Small exchange rate fluctuations will immediately affect their price levels. For example, a depreciation of the currency by a small open economy is more rapidly dissipated by price increases (import-price-push inflation), since its relatively high import ratio must entail larger direct upward effect of import prices on consumer prices, which might pass through into higher wage costs (wage-push inflation).

According to Peter Kenen the country most likely to be affected by severe shocks are those that have specialised in a narrow range of goods. A country whose economy is highly specialised, and highly interdependent on other countries, cannot even achieve gains through exchange rate adjustments at all. Suppose that France produces all the perfume in the EU and the UK all the whisky. Then a depreciation of the pond sterling cannot increase the production of the UK perfume industry, which does not exist, or of its whisky industry, which already has all the EU market. In such a extreme case, a depreciation of the domestic currency can only increase prices and would have no real effect even in the short run. However, although there are some products whose production in the EU is country-specific, most products are produced in several member countries and exchange rate changes do not necessarily increase the degree of diversification of an economy. A country in which an industry produces a substantial part if its GDP, yet has a small share of its foreign markets, may advantageously use exchange rate adjustments to cope with a shock which affect that industry. For example, if the steel industry were in a global recession, the country in which steel production was proportionately the largest might benefit most by the depreciation of its currency, which would increase its share of the world's consumption of steel. This would mitigate the unemployment in the undiversified, steel dependent country. To sum up: the more integrated and industrially similar the member states become, the less useful the exchange rate flexibility between them is likely to be. Appropriate exchange rate adjustments to increase production will then become less useful when the concerning trading countries are more diversified. This explains why the Kenen criterion states that countries whose production and exports are widely diversified and of similar structure form an OCA in which the exchange rate