International Economics ECON 390
Lotta Moberg
Lecture notes – 20 November 21: Optimum Currency Areas
The Theory of Optimum Currency Areas
1. Developed by Robert Mundell in 1961
2. The optimal area for a system of fixed exchange rates or a common
currency, is highly economically integrated with free flows of:
3. goods and services
4. financial and physical capital – reducing uncertainty about rates of return
5. workers/labor – reducing the uncertainty about the purchasing power of
wages
The monetary efficiency gain from fixed exchange rates in a currency union
6. Avoid uncertainty and international transaction costs
7. The law of one price is expected to hold better when markets are
integrated.
The economic stability loss from fixed exchange rates
8. No monetary policy
9. If insufficiently integrated, no automatic adjustment of exchange rates to
changes in aggregate demand
10. If economic integration is extensive and a currency union member faces a
fall in aggregate demand
 Relative prices fall, and other members increase aggregate demand, and
thus mitigate the economic loss.
 Financial assets or labor migrate to areas with higher returns or wages, thus
mitigating the economic loss
11. With high enough integration, the monetary efficiency gain to join a fixed
exchange rate system exceeds the economic stability loss.
12. With many and large changes in aggregate demand increases for a country:
 The economic stability loss increases
International Economics ECON 390
Lotta Moberg
The European Union
13. A system of international institutions with 28 member countries that
started in 1957
14. European Parliament: Elected by citizens of member countries
15. Council of the European Union: Appointed by governments
of the member countries
16. European Commission: Executive body
17. Court of Justice: interprets EU law
18. European Central Bank: Monetary policy through the European System of
Central Banks
The European Monetary System
19. Fixed exchange rates in 1979
20. The euro was adopted in 1999
21. EU members adopted the euro for 4 main reasons
 Unified market
 Political stability
 A belief that the system would moderate German influence
 Elimination of the possibility of devaluations
Is the EU an Optimum Currency Area?
22. Most EU members export from 10% to 20% of GDP to other EU members
23. Trade between U.S. states is much larger
24. Prices of goods and services are not the same across markets
25. Low regional migration
26. But capital mobility without labor mobility can make the economic stability
loss greater.
 After a reduction of aggregate demand in a particular EU country, financial
assets are easily moved out while labor is stuck.
27. Transfers between euro countries could offset the economic stability loss
28. But the EU has much less such fiscal federalism than the U.S.