According to the theory first developed by Mundell (1961) in order to be optimal, a currency area must be highly economically integrated, in that there is a free and substantial movement of goods and services, capital and labour. This would eliminate speculation and mean a great benefit from the elimination of transaction costs and uncertainty over exchange rates, less uncertainty over returns on investment and purchasing power of income across boundaries, and the labour markets would become more flexible and competitive, allowing workers broader horizons and better prospects.
In terms of real- world occurrences, these were some of the main arguments put forward in support of the creation of the Euro as a single currency for many EU members and earlier, the European exchange rate mechanism (ERM) which pegged currencies in for these same reasons, and in preparation for the single currency. In the theory, there is little or no distinction between the two (a common currency or an area of fixed exchange rates), since both of them achieve the same ends and have largely the same implications.
On the other hand there are of course disadvantages to having a common currency or exchange rate regime. Obviously the exchange rate management would no longer be available as a policy tool in specific regions, to encourage foreign investment for example. This would instead be decided by some central authority. Control over monetary policy also would similarly have to be relinquished by regional or national authorities to a common central bank, in the Euro’s case the European Central Bank (ECB).
In the case of many different currencies or floating exchange rates, individual regions can use interest rates to manage business cycle effects or counteract unexpected demand shocks; raising interest rates to discourage consumption when demand is excessive to combat inflation and lowering them to encourage spending and thus reduce unemployment when demand is low. Under a common currency however, there can only be one base rate across all regions, leading to the argument that a currency areas are undesirable since they lead to a one-size-fits-all monetary policy.
In the same way, the Mundell- Fleming model implies that under fixed exchange rates, it is impossible to maintain both free capital movement and an independent monetary policy. Bearing in mind the advantages of currency areas given above, these must be weighed against the disadvantages of losing monetary sovereignty in each case. Having deduced that the gains will be greatest when the area is highly economically integrated, we must determine when loss of independent monetary policy becomes a real problem.
As far as dampening business cycle effects is concerned, a shared monetary policy would become a problem where different areas under the same regime had dissimilar cycles. For example, if a large country was in recession in its East, but booming in the West, the central bank would either have to ease the situation in one region at the expense of aggravating the problem of the other or reach some compromise. Even if there is a degree of symmetry, there may be conflict if the scale of the shocks vary.
For example, if two regions, East and West, share a currency and the West has a far more marked business cycle than the East, a monetary policy ideal for the East during a boom would not be enough to properly curb inflationary pressure in the West, and a policy tailored to the West could prove too drastic for the East and could even force it into recession. In these scenarios, ceterus paribus, it would be beneficial have separate currencies for the East and West.
Thus we can see that where gains are greatest when an area is highly economically integrated whilst the stability loss from losing autonomous monetary policy is lessened. These principles are illustrated below. On the left, the GG schedule showing the efficiency gains of joining a currency area increasing as the degree of integration in the area increases. On the right, the LL schedule shows the economic stability loss diminishing as economic integration increases.
Putting the two together, as below, we see there is an intersect where as integration increases, the total gains begin to exceed the losses. It is also important to note in instances such as the Euro the limiting effect that the loss of monetary autonomy can have on fiscal policy, since segniorage can no longer be used to fund public sector deficits. This limits the extent to which fiscal policy can be used to counterbalance cyclical or random shocks although it could be seen in a positive way in that it might force governments to be more disciplined with their spending.
Depending on the political climate of the country, this limitation could prove important in deciding whether or not to join. Given the requirement of extensive integration for a currency area’s monetary policy to be fair and effective, applied work on optimal currency areas tends to focus on identifying actual optimal currency areas based on empirical evidence and determining if these correspond with existing currency regimes.
The Euro zone is naturally a common subject of scrutiny, with some examples being Eichengreen and Bayoumi (1993) whose study showed a high degree of asymmetry of the shocks affecting various EU member countries, which would suggest rather high monetary stability losses and Grauwe and Vanhaverbeke (1993) who demonstrate significant differences in labour mobility between the North and South of Europe and further evidence of asymmetric shocks.
Even in the case of individual countries, optimal conditions cannot be taken for granted, with some researchers claiming that the US does not constitute an OCA, such as Kouparitsas (2001) finding five different areas (potential OCAs) in which shocks are symmetrical, with asymmetry between these areas and three others, which according to the theory suggests the US would be better served by multiple distinct currencies with floating exchange rates.
On an intuitive level this makes some sense, since you would expect that any area the size of the US would have some ‘boom towns’ or states and other areas in decline, perhaps as a result of structural changes such as declining industries. Any US base rate decision would therefore have to be a compromise to some degree and would favour some regions more than others. A historical example of such a dilemna is the re-unification of East and West Germany in 1990, when West Germany’s central bank (the bundesbank) needed to lower its interest rates in order to stimulate growth in the stagnant East.
In summary, the loss of an autonomous monetary policy can lead to serious macroeconomic problems such as high inflation or unemployment which may remain unchecked because of the need to compromise between contrasting issues of different regions in the area. This is particularly the case when the shocks experienced by different regions are significantly different or asymmetrical, since this is when conflicting priorities arise.
Rigidities in the labour market can lead to long term structural unemployment under such circumstances, and regions could be sent into a very long term decline, even while other regions suffer high inflation and the economic and political instability it can create. Under such circumstances, the area would be better served by multiple currencies and hence monetary authorities in which exchange rates fluctuate in accordance with demand and supply changes.
However, the issue of monetary policy becomes redundant when the currency area is truly ‘optimal’, a flexible labour market would mean that workers could readily move throughout the entire area to find employment and meet the needs of the economy preventing structural unemployment, free movement of capital would ensure that surpluses and deficits of various forms of capital would not arise and would instead be allocated efficiently and substantial trade within the area would bring about the ‘law of one price’. There would be a symmetrical business cycle across the area and inflation and unemployment rates would converge.
Thus the area, when ‘optimal’ or highly integrated, would suffer no stability loss and a single monetary policy genuinely could fit the entire area. The reality, as mentioned with respect to the US and Europe, is likely to be somewhere in between the two extremes, either resulting in a situation in which the efficiency gains are outweighed by the stability losses or one in which stability losses do occur, but are justified on balance by the gains, in which case the best course of action is probably to persevere and encourage more economic integration in order to improve stability.
It is also important to remember, as Mundell pointed out in his original article, that these are the purely economic arguments and in reality, political considerations about the importance of monetary autonomy to national sovereignty are likely to play a part in real-world decision making.