A REVIEW OF THE THEORY OF OPTIMUM CURRENCY AREAS
- IMPLICATIONS FOR THE FUTURE OF THE EUROZONE
By
Joseph G Nellis
Professor of International Management Economics
Cranfield School of Management
1.
Background
Research into the nature of and implications arising from the establishment of
an optimum currency area (OCA) has been ongoing since the pioneering
work by Mundell (1961) and McKinnon (1963). The topic has increased in
significance in more recent years, particularly within the European Union, as a
result of the formation of euroland (or eurozone) on 1 January 1999
(membership increased to twelve on 1 January 2001 when Greece joined; at
the time of writing, there are 17 members in the eurozone). A heated debate
has been ongoing concerning the consequences of deeper European
integration and the economic costs and benefits of Economic and Monetary
Union (EMU) involving the creation of the single European currency, the euro.
This Review Paper on the theory of optimum currency areas provides a
background to this debate – a debate that some observers have suggested
has so far largely been centred on political dogma – and will hopefully serve
as a foundation for a more academically-based assessment. The topic has
also grown in significance in the context of the sovereign debt crisis which has
rocked a number of European states in recent years. The scale of the crisis
has led to speculation about the very survival of the euro currency itself and
the future pace of European integration (including not only monetary union
but also fiscal harmonisation – and, perhaps, ultimately political union).
Suggestions have been raised that it might be wiser for members to pause
and consider forming a “two-speed” eurozone with the strongest countries
forging ahead with ever-closer integration and the others taking a longer timescale to adjust.
Section 2 below defines the meaning of an optimum currency area and
reviews the arguments concerning flexible versus fixed exchange rate
regimes. The properties of an OCA are reviewed in Section 3 based on price
and wage flexibility as well as the degree of integration between regions. The
costs and benefits derived from participation in an OCA are set out in Section
4 while recent developments in research in this area and conclusions are
brought together in the final section along with some brief thoughts about the
future of the euro.
1
2.
Definition of an Optimum Currency Area
An optimum currency area refers to the ‘optimum’ geographical size within
which the general means of payments is:


either a single common currency (as in the case of the euro)
or a group of currencies whose exchange values are irrevocably
pegged to one another with unlimited convertibility for both current and
capital account transactions on the balance of payments, but whose
exchange rates fluctuate in unison against the major currencies from
the rest of the world.
In this context, the idea of an ‘optimum’ is defined in macroeconomic terms
with respect to the maintenance of so-called internal and external balance.
Internal balance is achieved at the optimal trade-off point between inflation
and unemployment – consistent with zero (or non-accelerating inflation) and a
rate of unemployment which is “voluntary” in the sense that the only people
unemployed are those who are unwilling to work at the going wage rate
(defined as classical unemployment).
This trade-off is appropriately
illustrated with reference to the Phillips curve (for details, see Phillips, 1958).
External balance is concerned with the maintenance of sustainable balance
of payments positions (i.e. the absence of persistent current account deficits
or surpluses).
The concept of OCAs was originally developed in the 1950s and early 1960s
in the context of research and analysis concerning the relative merits of fixed
versus flexible exchange rate regimes. There have been many early
supporters of flexible exchange rates, most notably Milton Friedman (1953),
who argued that a country experiencing price and wage rigidities should adopt
flexible exchange rates in order to maintain both internal and external
balance. Under a system of fixed exchange rates with price and wage
rigidities, any effort by policy makers to correct international payments
imbalances would result in unemployment (arising from an over-valued
currency and a consequent loss of international competitiveness) or inflation
(arising from an under-valued currency leading to rising import prices). In
contrast, under flexible exchange rates the induced changes in relative prices
and real wages (and hence international competitiveness) would, in the longrun, eliminate international payments imbalances without much of the burden
of real adjustment, in particular, on employment levels. Such an argument in
favour of flexible exchange rates provides support for the view that a country
should adopt a flexible exchange rate regime irrespective of its fundamental
economic characteristics, since market forces will ensure continuous
adjustment towards internal and external balances.
The main problem with Friedman’s logic concerning flexible exchange rates is
that it fails to recognise that countries fundamentally differ in so many ways –
for example, in terms of endowments of natural resources, productivity levels,
capital-labour ratios, skill levels etc. Given such differences, the theory of
2
optimum currency areas claims that, if a country is sufficiently highly
integrated with the “outside world” in terms of financial transactions, financial
mobility or commodity trading, then a fixed exchange rate regime (or, in the
extreme, a single currency) may be more effective and more efficient in
reconciling internal and external balances than a system of flexible exchange
rates.
This is the core of the argument put forward in recent years by
supporters of the euro, although a question remains concerning the extent to
which the degree of integration that has so far been achieved between the
current 17 members of the European Union is sufficient to provide an
appropriate foundation for the creation of a successful OCA, let alone a single
common currency. Supporters of the euro argue that integration is a dynamic
and ongoing process – and that criticism against the euro is, therefore
inappropriate (and, in some cases, based on nationalistic tendencies on the
part of some countries from outside the area). However, the recent “euro
crisis” has put the spotlight on those countries in the eurozone that have
failed to ensure appropriate structural and sustainable adjustments enabling
them to remain competitive and attractive to investors within the single
currency area.
As noted above, the pioneers of research into OCAs were Mundell (1961) and
McKinnon (1963). The focus of their research was an attempt to identify the
most fundamental economic properties required to define an ‘optimum’
currency area. In this context, recognition should also be given to the parallel
contribution by Ingram (1962).
Later research by a number of others
including Grubel (1970), Corden (1972), Ishiyama (1975) and Tower and
Willet (1976) moved the attention away from the required fundamental
properties of an OCA to an evaluation of the costs and benefits which stem
from OCA participation. Hamada (1985) later studied the implications of an
individual country’s decision to participate in an OCA from the standpoint of
social welfare.
The following sections provide a review of some of this
subsequent research.
3.
Properties of an Optimum Currency Area
The research into OCAs has led to the generally accepted conclusion that a
successful (i.e. sustainable) OCA requires five specific conditions to be met.
These conditions are concerned with the degree of:
1.
2.
3.
4.
5.
Price and wage flexibility
Financial market integration
Factor market integration
Goods market integration
Macroeconomic policy co-ordination and political integration
Conditions 2, 3 and 4 lie at the heart of the Single European Market
programme, instigated by the European Commission in 1986 to provide the
basis for the free flow of goods, services, people and capital. Completion of
this programme was, therefore, an essential prerequisite for the launch of the
euro project. We comment on each of these conditions in turn.
3
3.1
Price and Wage Flexibility
The extent to which price and wage flexibility exists within a country has been
at the heart of the debate surrounding the choice between fixed or flexible
exchange rate regimes.
Indeed, the assumed inflexibility of prices and
wages was the basis for Friedman’s argument in favour of flexible exchange
rates and the subsequent development of the optimum currency area
literature (although it is also worth mentioning here that Friedman did not
entirely dismiss the idea that a group of countries may fix their bilateral rates
of currency exchange with each other and let the rates fluctuate jointly against
the rest of the world – see Friedman 1953, p.193.)
To explain and clarify the significance of price and wage flexibility, consider a
geographical area made up of a group of regions (or countries). In this
context, it can be postulated that if prices and (real) wages are sufficiently
flexible throughout the wider area in response to changing conditions which
affect demand and supply, the regions in the area should be tied together by
a fixed exchange rate regime. Complete flexibility of prices and wages would
ensure that market clearance is achieved everywhere and would also
facilitate instantaneous real adjustment to disturbances affecting interregional payments without causing problems of growing unemployment and
internal imbalance. The ultimate real adjustment consists of ‘a change in the
allocation of productive resources and in the composition of the goods
available for consumption and investment’ (Friedman, 1953 p.182). The
required changes in relative prices and real wages accomplish such
adjustment, so that the need for inter-regional (i.e., intra-area) exchange rate
flexibility is avoided. Connecting the regions by a system of fixed exchange
rates is beneficial to the area as a whole because it eliminates (currency
exchange) transactions costs and stimulates competition arising from the
“transparency” of prices. These are two of the key arguments which are put
forward by supporters of the euro.
External balance is simultaneously
maintained by the joint floating of the area’s currencies against the rest of the
world, thereby avoiding persistent deficits on the current and capital accounts,
as well as by the greater degree of internal price-wage flexibility of the
balance of payments.
On the other hand, when prices and real wages are inflexible, the transition
towards ultimate adjustment may be associated with rising and persistently
high unemployment in one region and/or inflation in another. Some regions
may even suffer from a combination of stagnation of output and high inflation
– i.e. stagflation. This was the primary concern of commentators who initially
opposed the adoption of the euro within the European Union – and recent
developments within Europe have borne out many of their concerns,
especially in countries such as Spain, Greece, Portugal and Ireland. In such
situations, it is argued that exchange rate flexibility among the regions may
partially assume the role of price-wage flexibility in the process of real
adjustments to disturbances.
To counterbalance this argument, greater
degrees of internal financial, factor and goods market integration have been
4
proposed by a number of researchers as substitutes for exchange rate
flexibility so as to warrant the establishment of an optimum currency area.
This is the rationale for the call for greater fiscal harmonisation and ever
closer economic integration between members of the eurozone by some
commentators in recent times.
3.2
Financial Market Integration
Ingram (1962) has focused on the extent to which a high degree of internal
financial market integration can ensure a free flow of funds to finance interregional payments imbalances and ease the adjustment process within a
region. It is argued that a successful common currency area must be tightly
integrated with respect to financial markets if it is to be sustainable.
When an inter-regional payments deficit is caused by a temporary but
reversible disturbance, a free flow of capital can serve as a cushion to make
the process back to internal and external balance real adjustment smaller and
more manageable in terms of impact (or even unnecessary altogether).
Though financial capital flows (apart from those induced by differentials in
long-run real rates of return) cannot indefinitely sustain a deficit caused by a
persistent and irreversible disturbance (the benefactors are unlikely to be
willing to provide a bottomless pot of money to the beneficiaries), they allow
real adjustment to be spread out over a longer period of time. The cost of
adjustment is further minimised by the additional support derived from pricewage flexibility (noted above) and internal factor mobility (see 3.3 below), both
of which tend to be higher in the longer run.
In addition, financial transactions strengthen the long-term adjustment
process through so-called wealth effects. These stem from the fact that
surplus regions will be accumulating net claims and can therefore be
expected to raise their total expenditures while deficit regions will be decumulating net claims and thus lowering their total expenditures.
Both
effects will support real adjustment towards a sustainable balance in all the
regions of the optimum currency area – assuming that there is a willingness
on the part of all regions to take the appropriate steps.
It can thus be argued that financial market integration reduces the necessity
for inter-regional (i.e. intra-area) terms-of-trade changes via exchange rate
fluctuations, at least in the short-run. Considering the undesirable effects
arising from exchange rate flexibility (such as excessive volatility in currency
values combined with the negative impact on business confidence, capital
flows and investment) and the associated exchange rate risk, fixed exchange
rates may be preferred within the financially integrated area. The greater the
degree of financial market integration, the stronger will be the case for the
establishment of an OCA across the regions. Not surprisingly, a greater
degree of financial market integration has, therefore, been a key objective of
the euroland countries. However, the extent to which such integration has
taken place in reality since the birth of the euro has been the subject of
controversy and debate in the context of the recent European sovereign debt
and financial crises.
5
3.3
Factor Market Integration
Mundell (1961) has argued that an optimum currency area is defined by
internal factor mobility (including both inter-regional and inter-industry
mobility) and external factor immobility. Internal mobility of the factors of
production (particularly labour) can help ease the pressure to alter real factor
prices (e.g. wage rates) in response to disturbances affecting demand and
supply – and thus the necessity for exchange rate movements as an
instrument of adjustment of real factor price change can be avoided to some
extent. In this sense factor mobility is a partial substitute for price-wage
flexibility. This arises from the fact that the mobility of labour, for example, is
not frictionless in the short-run (most workers do not pack-up and move
house in search of new jobs or do not look for work in other sectors
immediately after being made redundant). Therefore, it is more effective in
easing the cost of long-run real adjustment to persistent payments
imbalances than short-run adjustment to temporary imbalances, which is
minimised by a greater degree of financial capital mobility and integration.
Hence, factor market integration reduces the extent to which a fixed
exchange rate regime interferes with the maintenance of sustainable interregional payments positions, while at the same time increasing the usefulness
of money as a medium of exchange inside the optimum currency area.
Internal balance (the optimum inflation-unemployment trade-off noted earlier)
can be secured by the adoption of appropriate domestic monetary and fiscal
policy measures, and external balance relative to the rest of the world can be
accomplished by the joint floating of the exchange rates against the rest of
the world (note, however, that membership of the euro means that each
member country is unable to pursue an independent monetary policy and, in
principle, has limited fiscal policy freedom as specified by the Maastricht
Treaty).
3.4
Goods Market Integration
The extent to which the USA has succeeded in achieving relative smoothness
of longer-run inter-regional adjustment over a long period of time is often
attributed to its high degree of internal openness.
This suggests that a
successful OCA area must have a free flow of goods and services, ensuring
extensive cross-border trading inside the area. The extent to which trade is
“free” to flow within a given area is often measured by such indicators as the
ratio of tradeable to non-tradeable goods in production or consumption, the
ratio of exports plus imports to gross domestic product, and the marginal
propensity to import.
McKinnon (1963) has raised the question of whether or not an area with a
high degree of openness with respect to the free flow of trade should choose
flexible exchange rates vis à vis other areas or unite with them to form a
larger optimum currency area. This throws up a number of issues. First,
suppose the area is externally highly open so that tradeables represent a
large share of the goods produced and consumed.
In this situation
6
exchange rate flexibility vis-à-vis other areas will not be effective in correcting
unsustainable payments imbalances, since any exchange rate adjustment
could be offset by price changes without any significant impact on the terms
of trade or on real wages (the extent of this will vary from country to country
depending on the causes of domestic inflationary pressures). It can be
argued, therefore, that the area is too small and open for expenditureswitching instruments to have sufficient impact, though wealth effects operate
in the direction of restoring external balance. The by-product is an unstable
general price level across the area generally and widening inflation
differentials between regions (as is currently the case in the eurozone).
Under these circumstances, the area would find it more beneficial to adopt
appropriate expenditure-switching policies (to reduce the demand for imports)
in order to achieve external balance and to adopt a fixed exchange rate
regime to support the aim of price stability, provided that the tradeable goods
prices are stable in terms of the outside currency.
Second, when the area is relatively closed against the rest of the world (as
represented by a large share of total export and import trade taking place
between members of the area itself), it should peg its currency to the body of
non-tradeable goods and adopt a floating exchange rate regime to support
the achievement of external balance.
Exchange rate flexibility in this
situation is effective because it brings about the desired changes in the
relative price of tradeable goods and real wage adjustment.
The conclusion from this discussion concerning goods market integration is
that the optimal monetary arrangements of an internally open economy which
is externally relatively closed would be to peg its currency (or currencies
jointly) to the body of internally traded goods – which are viewed as nontradeables from the standpoint of the outside world – to achieve price stability,
and to adopt externally flexible exchange rates for external balance. This, in
general terms, describes the long-term view of prospects for the eurozone
area economy.
Splitting such an economy into smaller regions with
independently floating exchange rates is not desirable, nor is attaching itself
to the outside world to become part of a larger currency area (such as one
based on a US$ standard). This raises the question as to whether or not the
UK should continue to float sterling against the euro – or opt instead to take
up membership of the euroland club. However, the recent sovereign debt
crisis in the euro area has, understandably, hardened opinion in the UK
against membership of the euro – and some observers have gone so far as to
suggest that it has killed off any possibility of UK membership forever!
3.5
Macroeconomic Policy Co-ordination and Political Integration
The research so far reviewed here demonstrates the case for an optimum
currency area when a group of regions has a high degree of internal market
integration for financial assets, productive resources (labour and capital) or
outputs. Other properties such as product diversity (see Kenen 1969) and
similarities in preferences for particular inflation-unemployment trade-offs
have also been proposed as relevant ‘criteria’ for the establishment and
sustainability of optimum currency areas. It is important to appreciate that
7
the smooth functioning of a currency area system is dependent on absolute
confidence in the permanent fixity of exchange rates and the unlimited
convertibility of member currencies inside the area (similarly in the case of a
single currency area such as the eurozone). If this is not the case, there is a
danger of instability to the system arising from the actions of foreign currency
speculators (recall, for example, the exit of sterling from the European
exchange rate mechanism in 1992 as Bank of England intervention on the
foreign exchange markets, as well as a sharp hike in UK short-term interest
rates, failed to turn the tide of capital outflows and halt a dramatic slide in the
value of the currency). These conditions for a sustainable OCA require close
co-ordination between the national monetary authorities and perhaps even
the creation of a supranational central bank (along the lines of the European
Central Bank in the case of the euro).
However, surrendering national
sovereignty over the conduct of monetary policy to a supranational authority
involves not only an economic, but also a political process as well as raising
questions involving national sovereignty (such questions are, understandably,
at the forefront of any debate about the possibility of the UK’s future adoption
of the euro).
In addition to a high degree of monetary policy co-ordination (and hence the
loss of monetary policy independence by member countries), some
harmonisation of fiscal policies across the OCA is also necessary. In the
face of shocks (such as a sharp slowdown in economic activity leading to
rising unemployment) affecting particular regions within the common currency
area differently, fiscal transfers away from the relatively prosperous regions
towards the adversely affected regions are desirable so as to counteract the
impact of the shocks and reduce the burden of real adjustment. It is argued,
therefore, that the tax systems inside the currency area must be coordinated
in order to avoid the disruptive effects that tax arbitrage behaviour might
engender (for example, different corporate tax rates across the area could
encourage firms to relocate to lower tax regions). It is not surprising,
therefore, that the issue of fiscal harmonisation has been a hotly debated
topic within the eurozone – especially in recent times as some countries have
deliberately flouted or have been forced to ignore the fiscal rules specified
within the Maastricht Treaty.
The experience of the European Monetary System (EMS) after its inception in
1979 and the associated Exchange Rate Mechanism (ERM) has indicated
that, without commitment to reaching some form of political integration,
managing a currency area as loose as the EMS/ERM is not a simple task
(note that the ERM is still in operation following the birth of the euro; other
countries which wish to join the euro must be inside the ERM and report a
stable exchange rate against the euro for at least two years prior to joining the
euroland group). The EMS/ERM may be labelled as a “loose” currency area
or a ‘pseudo-exchange-rate union’ (Corden 1972) because occasional
currency realignments are allowed (and indeed many have been carried out
in the past). Such political commitment can serve as a driving force behind
monetary integration and stronger fiscal policy co-ordination.
8
4.
Costs and Benefits of Currency Area Participation
In order to provide a detailed assessment of the welfare implications arising
from participation in an optimum currency area, one would ideally like to
examine how the entire world economy should be divided into independent
currency areas to maximise global welfare. This approach, of course, is
impractical – we do not have the luxury to conduct such an experiment at will.
However, a number of research studies have been conducted within a more
practical and narrower geographical framework to assess the costs and
benefits of OCA participation. Cost-benefit studies by economists such as
Ishiyama (1975) and Tower and Willet (1976) have focused on the specific
question of whether selected countries should unite with one another to form
an optimum currency area. Each country may be assumed to evaluate the
costs and benefits of currency area participation from a purely nationalistic
point of view. However, the drawback of such a restricted approach is that a
‘nationally’ optimum currency area thus determined may not coincide with a
‘globally’ optimum currency area – the pursuit of self-interest by the individual
nations or of the area as a whole may not be in the best interests of the global
economy (such self-interest could manifest itself in terms of growing
protectionism with respect to international trade).
4.1
Costs of OCA Participation
A flexible exchange rate regime, at least in principle, allows each country to
retain a degree of domestic monetary policy independence. However, a
fixed exchange rate requires unified or closely co-ordinated monetary policy,
constraining the participating countries’ freedom to pursue independent
monetary policies (membership of a single currency area means a complete
loss of monetary sovereignty). This loss of monetary policy independence is
considered to be the most important cost of participating in an OCA since it
may force the member countries to depart from internal balance for the sake
of the maintenance of fixed exchange rates. The cost is deemed large if the
country has a low tolerance for unemployment and is subject to strong price
and wage pressures from monopolistic industries, labour units and long-term
contracts. On the other hand, the cost may be small if it faces a relatively
vertical Phillips curve (as in the case of a small, highly open economy),
because in such a case the country would not have much freedom to choose
the best inflation-unemployment trade-off in the first place (for details
concerning the meaning and implications of a vertical Phillips curve see Nellis
and Parker, 2004, pp. 274-279).
4.2
Benefits of OCA Participation
The primary benefit to a country from participation in an optimum currency
area is that the usefulness of money is enhanced (Mundell 1961; McKinnon
1963; Kindleberger 1972; Tower and Willet 1976). Money as a medium of
exchange and unit of account simplifies economic calculation and accounting,
economises on acquiring and using information for transactions, and
9
promotes the integration of markets, both goods and financial. The use of a
single common currency (or currencies rigidly pegged to one another with full
convertibility) within an OCA would eliminate the risk of future exchange rate
fluctuations, maximise the gains from trade and specialisation and, thus,
enhance allocative efficiency (through an optimum allocation of scarce
resources between end uses). The usefulness of money generally rises with
the size of the domain over which it is used as a medium of exchange – i.e.,
the larger the currency area, the greater the benefits derived from the use of
a single currency.
There is also a number of spillover effects (i.e. externalities) which stem from
the benefits described above. First, participation in an OCA means that each
member country pegs its currency to the class of representative goods traded
in the wider area. Hence, a financially unstable country can enjoy a high
liquidity value of money by joining a more financially prudent currency area.
Secondly, a financially well-integrated OCA supports risk-sharing between the
member countries. An inter-regional payments imbalance is immediately
accommodated by a flow of financial transactions, which enable a deficit
country to draw on the resources of the surplus countries until the adjustment
cost is efficiently spread out over time – depending, of course, on the
willingness of surplus countries to provide support to the deficit countries.
4.3
Balance of Costs and Benefits
It is difficult to assess the balance of OCA participation with respect to the
costs and benefits outlined above. Arguments on both sides can be deemed
to be more or less important depending on the circumstances prevailing at
various points in time. The formation of an OCA must, therefore, be seen as
a dynamic process.
In terms of the progress towards closer integration
involving more complete monetary integration, the confidence of the public
and the markets will grow over time. At the same time, some new benefits
can be expected to emerge, the significance of existing benefits may
increase, and the costs may diminish. Thus, intertemporal balancing of the
benefits against the costs is necessary. It can be postulated, therefore, that
an individual country will decide to participate in a currency area if the
expected (discounted value of future) benefits exceeds the expected
(discounted value of future) costs.
In assessing the benefits and costs in order to reach a conclusion, two
caveats are important to note. First, the country is assumed to compare two
extreme exchange rate regimes – i.e., an irrevocably fixed exchange rate
system and a free-floating flexible exchange rate system. However, from the
viewpoint of maximising the social welfare of the country (in terms of benefits
minus costs), there will almost always be an optimal exchange market
intervention strategy that allows some exchange rate flexibility and some
changes in external reserves. Hence, the polar cases of fixed and flexible
exchange rates are unlikely to be optimal – see for example the research
reported by Boyer (1978), Roper and Turnovsky (1980) and Aizenman and
Frenkel (1985).
10
Second, a small open economy has the freedom to choose the best
exchange rate arrangement on the assumption that its choice of policy will not
affect the rest of the world (in terms of the volume of capital flows, currency
speculation and interest-rate stance).
This decision, however, may be
affected to some degree by the nature of the policies being pursued by other
countries. If the economy in question is not small, the ‘optimum’ currency
area thus determined may not be ‘globally’ optimum. As emphasised by
Hamada (1985), when the important benefits of currency area formation
exhibit public-good characteristics and externalities and the costs are borne
by individual countries, the rational theory of collective action (e.g., Buchanan
1969) suggests that individual countries’ participation decisions tend to
produce a currency area that is smaller than is optimum from the viewpoint of
society’s welfare. Note, however, that if the public-bad character of the costs
dominates the public-good character of the benefits, the resulting currency
area based on individual calculations may well be larger than that which is
globally optimum.
The proposed approach of participation (weighing up
benefits and costs) obviously neglects a wider variety of strategic interactions
among countries; there is no leader-follower relationship and no bargaining or
co-operation. Such a game-theoretic approach to optimal exchange rate
arrangement has attracted other economists’ attention – see Cooper (1987),
Hamada (1985), Canzoneria and Gray (1985) and various research papers in
Buiter and Marston (1985).
5.
Conclusions
This review of the theory of OCAs and the research surrounding the
fundamental characteristics as well as the benefits and costs associated with
membership, has pulled together a number of issues which merit further
attention.
First, the choice between flexible and fixed exchange rate regimes should be
understood as a second-best solution to the challenges facing economies
which exhibit a degree of “friction” (see Komiya 1971). If the markets for
outputs, factors of production and financial assets were completely integrated
on a world-wide scale, relative prices and real wages were perfectly flexible,
and economic nationalism (which attempts to insulate a national economy
from the rest of the world by way of artificial impediments to trade, capital
movements and foreign exchange transactions) were absent, then the
optimum currency area would be the whole world!
In such an idealistic
situation, the real adjustment to external imbalances would be extremely
smooth and relatively painless, factor resources would always be fully
employed, and the usefulness of money as a medium of exchange would be
maximised (indeed, if the whole world used a single, common currency there
would be no issues to be addressed – on a worldwide basis there would be
no external imbalances in trade). However, to the extent that the adjustment
mechanism is impaired by market fragmentation and price-wage rigidities, a
country may adopt flexible exchange rates as a second-best policy to attain
internal and external balance.
A review of the optimum currency area
literature has shown that measures of market integration (concerning financial
11
assets, factor resources and goods) may be more effective, albeit partial,
substitutes to price-wage flexibility than is exchange rate flexibility.
Second, the cost-benefit approach to optimum currency areas based on
purely national interest must be the starting point in the analysis of designing
an optimum international monetary system. Given the degree of spill-over
effects and economic interdependence among closely integrated countries,
the strategic behaviour on the part of national policymakers must be
incorporated explicitly in order to deepen our understanding of the nature of
‘globally’ optimum currency areas and optimal international monetary
arrangements.
Finally, it is interesting to note that the two economists who first advanced the
theory of optimum currency areas, Mundell and McKinnon, also came to
support fixed exchange rates. Mundell has advocated a world-wide gold
standard system and McKinnon (1984) a fixing of the exchange rates among
the three major industrialised countries (USA, Germany and Japan). Thus
they regard the world as a whole (or at the least the major western)
industrialised nations as capable of establishing an optimum currency area on
a global scale. We are left wondering to what extent the possibility of such a
currency arrangement is ever likely to exist – especially in the light of the
rather contrasting performances of the USA, German and Japanese
economies over the past two decades. Developments in the eurozone will,
undoubtedly, have major and long-lasting implications concerning the pace of
closer integration within the European Union. More and more attention is
being focussed on the need for fiscal harmonisation between the euro
member states in order to avoid renewed sovereign debt crises in the future.
This issue is central to the very future and survival of the euro itself – but the
extent to which all member governments are prepared to relinquish fiscal
sovereignty has yet to be tested. It is hoped that this review of OCA research
will provide a useful platform and background for discussions concerning the
future of a single common currency in Europe.
References
Aizenman, J and Frenkel, J 1985, Optimal wage indexation, foreign exchange
intervention and monetary policy, American Economic Review 75(3), June:
402-23.
Boyer, R S 1978, Optimal foreign exchange market intervention, Journal of
Political Economy 86, December: 1045-55.
Buchanan, J M 1969, Cost and Choice, Chicago, Markham.
Buiter, W H and Marston, R C (eds) 1985, International Economic Policy
Coordination, Cambridge; Cambridge University Press
12
Canzoneri, M B and Gray, J 1985, Monetary policy games and the
consequences of non-co-operative behavior, International Economic Review
36(3), October: 547-64
Cooper, R N 1987, The International Monetary System, Cambridge, Mass:
MIT Press
Corden, W M, 1972, Monetary Integration, Essays in International Finance No
93, April, Princeton: International Finance Section, Princeton University.
Friedman, M, 1953, The case for flexible exchange rates, In M Friedman,
Essays in Positive Economics, Chicago: University of Chicago Press
Grubel, H G, 1970, The theory of optimum currency areas, Canadian Journal
of Economics 3, May: 318-24
Hamada, K, 1985, The Political Economy of International Monetary
Interdependence, Cambridge, Mass: MIT Press
Ingram, J C, 1962, Regional Payments Mechanisms: The Case of Puerto
Rico, Chapel Hill: University of North Carolina Press
Ishiyama, Y, 1975, The theory of optimum currency areas: a survey, IMF Staff
Papers 22 July: 344-83
Kenen, P B, 1969, The theory of optimum currency areas: an eclectic view.
In Monetary Problems of the International Economy, ed R A Mundell and A K
Swoboda, Chicago: University of Chicago Press
Kindleberger, C P, 1972, The benefits of international money.
International Economics 2, September: 425-42
Journal of
Komiya, R, 1971, Saitekitsukachiiki no riron (Theory of optimum currency
areas). In Gendaikeizaigaku no Tenka (The development of contemporary
economics), e. M Kaji and Y Murakami, Tokyo: Keisoshobo
McKinnon, R I, 1963, Optimum currency areas. American Economic Review
53, September: 717-25
McKinnon R I 1984, An International Standard for Monetary Stabilization.
Policy Analyses in International Economics 8, March, Washington, DC:
Institute for International Economics
Mundell, R A, 1961, A theory of optimum currency areas.
Economic Review 51, September: 6457-65.
American
Nellis, J G, and Parker, D, 2004 Principles of Macroeconomics , Prentice Hall.
13
Phillips, A W 1958, The relation between unemployment and the rate of
change in money wage rates in the United Kingdom 1861-1957, Economics
25, November: 283-99.
Roper, D E, and Turnovsky, S J, 1980.
Optimal exchange market
intervention in a simple stochastic macro model.
Canadian Journal of
Economics 13, May: 269-309
Tower, E, and Willet, T D, 1976, The Theory of Optimum Currency Areas and
Exchange-Rate Flexibility. Special studies in International Economics No 11,
May, Princeton: Princeton International Finance Section
Yeager, L, 1976. International Monetary Relations: Theory, History, Policy.
2nd edn, New York: Harper & Row.
14