Optimal Currency Area

Robert Mundell founded optimal currency area theory in the 1960s. It states that the optimal area for a fixed exchange rate system is one with high economic integration.

Economic integration displays the free flow of the following factors.

1. Goods and services
2. Labour (including both emigration and immigration)
3. Physical and financial capital

With an increase in a number of independent nations (globally) and an increase in integration of their economies, multi-nation currency unions are also expected.

It is interesting to note that in a fixed exchange rate systems, the following things are noticed.

1. There is a huge reduction in transaction costs when extensive trade ensues between member countries.
2. Free migration of labourers (across borders) for work can drastically cut uncertainties regarding wages.
3. Free flow of financial capital among member nations goes a long way in reducing uncertainty regarding the rate of return.

In summary, a gain in monetary efficiency from a fixed exchange rate system is correlated with the degree and scale of economic integration. However realization of monetary efficiency gain depends on certain assumptions (some of which are mentioned below).

• Assumption 1: Members belonging to a system of fixed exchange rates maintain a stable price level.
• Assumption 2: Any new member would in principle fully agree to a system of fixed exchange rates.

So in reality, either existence of variable inflation (among member countries) or event of a new member nation leaving this system would fail to dissipate or reduce ‘uncertainty’ to desired levels. In general, a higher level of economic integration is inversely related to the level of loss of economic stability. Advantages of a common currency from point of view of microeconomics are primarily in the form of savings in transaction costs. Common currency is also slated to create greater price transparency. Market segmentation and price discrimination are low in this framework. From a macroeconomics point of view most contentious issue regarding monetary union is implications regarding stabilization policy of a country.

Cite Term

Definition Sources