Theory of an Optimum Currency Area

The creation of the European Monetary Union (EMU) and moreover the current disparities within has renewed interest in investigating the costs, benefits and optimality of currency unions. Much of the discussion and empirical work has drawn from the theory of an Optimum Currency Area. With regard to a region with a single currency, Mundell (1961) the pioneer of this theory, implicitly defined an optimum currency area where which the costs of relinquishing the exchange rate as a mechanism for adjustment are outweighed by the benefits of membership in the union.1 When the expectation exists that benefits will be significant a country will surrender direct control over their monetary policy and exchange rate ( Mongelli 2002)

Since Mundell seminal work several other authors, notably McKinnon (1963) and Kenen (1969) have made important additions and the theory has evolved considerably. The outcome is a set of criteria or properties that these authors deem a pre requisite to a successful currency union.

OCA can be defined as "the optimal geographic domain of a single currency, or of several currencies, whose exchange rates are irrevocably pegged. The single currency, or the pegged currencies, can fluctuate only in unison against the rest of the world" (Mongelli, 2001, p. 1).

2.1.1 Mundell Factor Mobility

Mundell (1961) introduced the concept and coined the phrase Optimum Currency Area .The cornerstone of his theory is that when countries are exposed to symmetric shocks, or possess mechanisms for the absorption of asymmetric shocks they may find it optimal to adopt a common currency. The stronger these links the greater the chance of success for the union.

Mundell really emphasised this factor mobility paying particular attention to labour mobility. Mundell explains his theory using several possible scenarios for regions operating with a fixed exchange rate regime. For instance he sets the scene where some shift in these fixed exchange rate regions causes demand to move from a country A to country B. If prices and wages are rigid then region B will experience inflationary pressures while region A will suffer increased unemployment. Both regions now have balance of payments disequilibria. Without the exchange rate as a mechanism to absorb the shock Mundell proposes that labour mobility could restore balance.

With high labour mobility labour will move from country A to country B reducing the pressures. If this mechanism works then one common monetary policy will be satisfactory for both regions.