Special Topics in Economics Special Topics in Economics Econ. 491Econ. 491

Chapter 3:Chapter 3:

Optimum Currency AreaOptimum Currency Area

( OCA )( OCA )

I. Theory of Optimum Currency Areas I. Theory of Optimum Currency Areas (OCA)(OCA)

The currency crises in Mexico (1994), Asia (1997), The currency crises in Mexico (1994), Asia (1997), Russia (1998),& Brazil (1999) have fueled the Russia (1998),& Brazil (1999) have fueled the debate on the optimal choice of exchange rate debate on the optimal choice of exchange rate regimes. regimes.

The determinants of exchange rate policy have The determinants of exchange rate policy have been examined empirically using models based on been examined empirically using models based on the theory of Optimal Currency Areas (OCA).the theory of Optimal Currency Areas (OCA).

The theory was developed by Robert Mundell in 1961.The theory was developed by Robert Mundell in 1961.

The theory of The theory of optimum currency areasoptimum currency areas argues that the argues that the optimal area for a system of fixed exchange rates, or a optimal area for a system of fixed exchange rates, or a common currency, is one that is common currency, is one that is highly economically highly economically integratedintegrated..

This theory stresses that there is no single exchange rate This theory stresses that there is no single exchange rate

policy that performs best for all countries (Mundell, policy that performs best for all countries (Mundell, 1961).1961).

Economic Integration states FTA, Customs Union, Economic Integration states FTA, Customs Union, Common Market, Monetary Union. Common Market, Monetary Union.

Monetary union consists of :Monetary union consists of :

(Unified Common Currency– Unified Central Bank )(Unified Common Currency– Unified Central Bank )

A common currency ( a single currency zone, monetary union) is one A common currency ( a single currency zone, monetary union) is one where the accepted means of payment consists of a single homogeneous where the accepted means of payment consists of a single homogeneous currency linked by an exchange rate that is fixed ( at one for one) currency linked by an exchange rate that is fixed ( at one for one) irrevocably.irrevocably.

Monetary union can be viewed as the extension of a fixed exchange rate Monetary union can be viewed as the extension of a fixed exchange rate regime to a point where the possibility of parity changes is ruled out regime to a point where the possibility of parity changes is ruled out completely.completely.

Can USA be an OCA?Can USA be an OCA?

II. Monetary Union ( Common Currency)II. Monetary Union ( Common Currency)

Costs of common currency are that they require Costs of common currency are that they require the loss of the loss of monetary policymonetary policy for stabilizing output and employment, and for stabilizing output and employment, and the loss of automatic adjustment of exchange rates to changes the loss of automatic adjustment of exchange rates to changes in aggregate demand. in aggregate demand. How !!How !!

Other cost is that the loss of country’s sovereignty . Other cost is that the loss of country’s sovereignty . How !!How !!

III. Costs of the Monetary Union III. Costs of the Monetary Union ( Common Currency) ( Common Currency)

A common currency (Fixed exchange rate) has costs and A common currency (Fixed exchange rate) has costs and benefits for countries deciding whether to adhere to them.benefits for countries deciding whether to adhere to them.

The ultimate goal for the MU is to increase the level of The ultimate goal for the MU is to increase the level of bilateral trade.bilateral trade.

Benefits of common currency are that they avoid the Benefits of common currency are that they avoid the uncertainty and international transaction costs that floating uncertainty and international transaction costs that floating exchange rates involve.exchange rates involve.

Reducing the transaction costsReducing the transaction costs

Reducing the exchange rate volatilityReducing the exchange rate volatility

IV. Benefits of the Monetary Union IV. Benefits of the Monetary Union ( Common Currency) ( Common Currency)

How does a region determine whether a currency area would How does a region determine whether a currency area would provide net benefits?provide net benefits?

The literature on optimal currency areas suggests that a region The literature on optimal currency areas suggests that a region is likely to gain from a common currency if:is likely to gain from a common currency if:

1)1) A large share of members’ trade occurs with other members. A large share of members’ trade occurs with other members. How!!How!!

2) The region is subject primarily to common shocks that affect 2) The region is subject primarily to common shocks that affect the entire area similarly & not to shocks that affect sub-regions the entire area similarly & not to shocks that affect sub-regions differently.differently. How!! How!!

V. Who Should Use a Common Currency V. Who Should Use a Common Currency

3) Labor is mobile within the region.3) Labor is mobile within the region. How!! How!!

4) A tax-transfer system exists to transfer resources from sub-4) A tax-transfer system exists to transfer resources from sub-regions performing strongly to those performing poorly.regions performing strongly to those performing poorly. How!!How!!