The Theory of Optimum Currency Areas Essay

The Theory of Optimum Currency Areas Essay

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The theory of optimum currency areas (OCA) explores the conditions under which a common currency can maximize the economic efficiency of a region. It strives to identify the essential characteristics for forming a common currency zone as well as its possible costs and benefits. The research has also provided much insight into the area of optimum exchange rate management.
The phrase ‘optimum currency area’ was first coined by Mundell in 1961 in his seminal paper entitled “A Theory of Optimum Currency Areas”. Since then the theory has seen little development and the subject area has often lacked attention from economists. However, the formation of a European Monetary Union (EMU) has stimulated a resurgence of interest in the topic. (Citation)
The creation of the EMU has been an ambition of the European Union (EU) since the late 1960s. However, the timeline for achieving the EMU and a common currency was not agreed upon until the signing of the Maastricht Treaty of 1992. The treaty eliminated the national barriers to the movement of goods, labour and capital within the EU, as well as planning the creation of the euro currency and the European Central Bank. (Bean, 1992) The euro was finally adopted on the 1st Dec 1999 by eleven of the EU countries - as well as the Vatican, Andorra, Monaco and San Marino - and has subsequently been expanded further to Greece, Slovenia, Cyprus, Malta, Slovakia, Montenegro and Estonia. (Citation)
When Mundell introduced the OCA theory, the EMU was not a consideration and it was merely seen as an academic question. Mundell began by defining a currency area as “a domain within which exchange rates are fixed” and posed the prominent question “What is the appropriate domain of a currency area?”. To tackl...

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...f incomes and extent of trade amoung the members. The OCA line is downward sloping as the advantages of a common currency depend positively on trade and negatively on income correlation. The higher and further right the points are the more benefitial a common currency would be. Points that are low and left should float their own individual currency. He declared that a common currency for Germany, Belgium, Luxembourg and Netherlands would be advantageous but would be a hindrance for Europe as a whole. However, Frankel outlined that “The OCA Criterion Might Be Satisfied Ex Post, Even If Not Ex Ante”. He expanded by stating that through the formation of a common currency area countries that were below the OCA line could end up above it. Frankel indentified this would happen due to increased trade integration which causes a higher income correlation. (Frankel, 1999)

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