Optimum Currency Area

A natural starting point when beginning to study Optimum Currency Area (OCA) theory is the work of Lerner (see Scitovsky (1984)). Lerner discusses the benefits of variable exchange rates, and he argues that variable exchange rates will make it easier to maintain a steady level of employment and growth. Which leads to the question, why restrict variable exchange rates to countries; what is an optimum currency area?

Robert A. Mundell laid the first brick in the foundation of optimum currency area theory with his work, “A theory of Optimum Currency Areas” from 1961, and is therefore considered as one of the pioneers of OCA-theory. Mundell argues that a key element is the mobility of production factors, such as labour and capital, as well as that the argument for a national flexible exchange rate is only as valid as the Ricardian assumption¹ regarding production factor mobility. It is necessary with a close to perfect factor mobility of production factors in order for asymmetrical shocks not to create imbalance between the regions.

Mundell also pointed out that another key element is that the homogeneity levels of the regions must be roughly the same in order for the effects of monetary policy to be

1 An important assumption in the Ricardian model is that labour is mobile across industries within a country without additional cost or friction, but is immobile across countries.

symmetrical in the different regions. This worked as a theoretical starting point for the on-going discussion at that time regarding a Western European union, which captivated famous economists as J. E. Meade (1957) and Tibor Scitovsky (1984). Both arguing for and against a union with arguments quite similar to those used fifty years later in the origin of euro currency.

The third great contributor on the field is Roland I. McKinnon, who in 1963 published his work “Optimum Currency Area” where he constructed a model consisting of tradable and non-tradable goods. The model is meant to show that the ratio of a country´s tradable and non-tradable goods must be roughly similar for the regions constituting a possible Optimum Currency Area (OCA). In the model, non-tradable goods are goods that cannot be shipped abroad and are therefore domestically consumed, while tradable goods are import and export. Two countries sharing the same ratio should then be of similar degree of homogeneity, according to the model. Sharing the same degree of homogeneity will then qualify the region as a possible OCA since they both would respond well to a common interest rate. If the ratios of the two countries were dissimilar, the country with higher level of non-tradable goods would respond less to a change in the exchange rate, making a possible union vulnerable for asymmetric shocks.

Kenen (1969) argues that diversity in industrial production within nations is another claim that must be fulfilled in order for a region to be considered an OCA. The argument is that in a diversified region asymmetric shocks will even out over time, relative to a specified region and given high mobility of production factors within the region.

Magnifico (1973) makes another important and still highly relevant argument within OCA-theory, due to the history of the member countries. Magnifico argues that the different countries must share the same propensity to inflation. If the countries utilize the same level of productivity factors, but have different levels of inflation, it may indicate that the countries do not have the same propensity to inflation. Different socio-institutional structural differences, strong unions, social expectations etc. may cause such differences.

Martin (2001) identified four homogeneity criteria for a region in order to classify as an OCA. Three of them mentioned above, and the last one being automatic fiscal mechanisms through a centrally-organized tax-benefit system. These mechanisms are meant to compensate for temporary differences in growth and impact of asymmetric shocks in the

different regions. It is assumed that the sum of the compensations between the regions will add up to zero, in the long run. These inter-region mechanisms are intended to function in the same way as social security benefits, taxation, etc. do within a country. Since there are no region-specific currencies or exchange rates in an OCA, these mechanisms are to compensate for such absence.

The four homogeneity criteria may be summed up as followed:

• Economies should be roughly similar and synchronized. This is to ensure that shocks are also symmetrical, so that when a shock occurs, all member states are affected in roughly the same way and, hence, they will also be affected in roughly the same way by a centralized currency policy.

• Full capital and labour mobility. Such factors must be able to move freely between the regions if asymmetric demand and technology shocks are not to result in regional imbalances in economic development and growth.

• Regions should have similar propensities to inflation. Large differences in propensity to inflation could cause instability to the system. For instance, if a central decision is carried out aimed at stemming price increases originating from regions with high propensity to inflation, this is likely to be harming to industry and jobs in regions with low inflation propensity.

• A centralized tax-benefit system to compensate for differential national and regional shocks and growth. By entering a currency union, a country concedes its monetary policy upwards to a centralized body, thus depending on being integrated into a corresponding centralized system of automatic fiscal stabilizers.

The importance and emphasis on each of these homogeneity criteria are difficult, if not impossible, to determine and will most likely vary from each potential OCA. In the pre-euro currency years, neoclassical growth models and models of regional growth predicted different outcomes of a common currency in the EU. Neoclassical models predicted that a common currency would lead to inter-country convergence, while regional growth models predicted divergence. The theoretical framework of OCA provides us with a method for analysing the underlying reasons for an OCA´s success or failure.