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RESEARCH PRODUCT

The Economics of Monetary Union: The Theory of Optimum Currency Areas

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In the 1960s, the theory of Optimum Currency Areas (OCAs) emerged as a by-product of the theoretical debate between fixed and flexible exchange rates. The OCAs approach singles out an economic characteristic to define an economic domain where there is exchange rate fixity erga intra, while there is exchange rate flexibility erga extra. In an optimum currency area, exchange rates fixity prevails internally without any type of internal or external disequilibrium. Each single characteristic ensures that floating or regular adjustments in nominal exchange rates are neither necessary, efficient nor desirable for stabilisation purposes. The literature proposes several economic criteria: factor mobility (Mundell); openness of the economy (McKinnon); product diversification (Kenen); national propensity to inflate (Magnifico); financial integration (Ingram); real exchange-rate changes (Vaubel). While the cost-benefit approach considers OCAs criteria for guaranteeing long-term equilibrium, this approach is operational and focuses on the political commitment of countries to form a monetary union assessing the resulting costs and benefits. Benefits are associated with efficiency and price stability gains, reduction of risks arising from exchange rate uncertainty, and gains from using the euro as a reserve currency; while costs relate to the loss of monetary independence, diverging preferences in national inflation-unemployment relationships, and worsening regional disequilibrium.