2.1 The Theory of Optimum Currency Areas (OCA)
In 1961, Robert Mundell published the article “A theory of optimum currency areas” (Mundell, 1961). At this time, participating countries of the Bretton Woods system had pegged their national currencies to the US dollar which again had a fixed exchange rate to gold. In his article, Mundell (1961) questions: What is the appropriate domain of a currency area? Mundell stresses that the flexible exchange rate is presented as a “device whereby depreciation can take the place of unemployment when the external balance is in deficit, and appreciation can replace inflation when it is in surplus” (Mundell, 1961, p. 657). A single currency area implies a single central bank, which will challenge possible needs of adjustment between countries. Mundell’s discussion entails these needs of adjustments under a fixed exchange rate regime. Mundell (1961, p. 657) states that:
“It is patently obvious that periodic balance-of-payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the terms of trade from fulfilling a natural role in the adjustment process.”
Mundell argues that the optimum area for a single currency is a region, or an economic unit, within each of which there is factor mobility and between which there is factor immobility. Each region should have a separate currency which fluctuates relative to all other currencies.
When discussing the practical application of his theory, Mundell stresses that it is based on the Ricardian assumption that factors of production are mobile internally, but immobile internationally. He argues that the argument for flexible exchange rate based on national currencies, is only as valid as the Ricardian assumption about factor mobility. Meanwhile, “if regions cut across boundaries or countries are multiregional, then the argument for flexible exchange rates is only valid if currencies are reorganized on a regional basis” (Mundell, 1961, p. 661).
Such reorganization should be possible if it is accompanied by a “profound political change” as the currency is an expression of national sovereignty (Mundell, 1961, p. 661). To achieve equilibrium with fixed exchange rate, it is thus important that fiscal policy is appropriately mixed with monetary policy. If monetary policy is contractionary, fiscal policy should be shifted to expansionary, and vice versa. This leads to Mundell's assignment rule: Assign to fiscal policy the task of stabilizing the domestic economy only, and assign to monetary policy the task of stabilizing the balance of payments (Pugel, 2007).
2.2 The Mundell trade-off and the OCA properties
The OCA theory is often used as a benchmark for the analysis of the costs and benefits of monetary integration in trade unions, and other authors base their research on Mundell’s work. McKinnon (1961) and Kenen (1969) are important contributors in this literature by establishing properties for an optimal currency area.
The OCA theory postulates that benefits can be gained in a currency union with a common monetary policy if the countries forming a monetary union share certain common characteristics. The economic benefits from a single currency and monetary institution derive from eliminated transaction costs of doing business with many different currencies, and eliminated risks to business associated with fluctuating currencies. Whether the increased trade within a monetary union represents a net benefit depends on the relative importance of trade-creating effects - meaning the increased trade among the member countries - and trade- diverting effects - meaning the diversion of existing imports from countries outside the monetary union to countries inside it (Feldstein, 1997). The economic costs of giving up national currency might be substantially higher than the benefits. Moving monetary policy authority to a union-wide central bank means that monetary policy and the exchange rate cannot be tailored to fit national conditions, but must be collectively decided for the whole union.
The trade-off between stabilization losses and transaction cost reductions is called the Mundell trade-off. The OCA theory argues that a collective monetary policy is
there are compensating fiscal transfers across the monetary union to make up for uneven economic development, and that business cycles are synchronized. These characteristics are called the OCA properties (McKinnon, 1961; Kenen, 1969).
The latter property is seen as the most important one, and form the basis of this thesis.
2.3 Business cycles and business cycle synchronization
Business cycles are economy-wide fluctuations in economic activity, meaning that the state of the economy repeatedly alternates between business cycle expansions characterized by rapid growth, and business cycle recessions characterized by declining economic activity (Sørensen & Whitta-Jacobsen, 2010).
The American economists Arthur Burns and Wesley Mitchell (1946) emphasize several points in their definition of business cycles. Firstly, business cycles are characterized by a co-movement of a large number of economic activities.
Secondly, business cycles are a phenomenon occurring in decentralized market economies. Thirdly, business cycles are characterized by periods of expansion of economic activity followed by periods of contraction in which economic activity declines. Fourthly, a full business cycle lasts for more than a year, or more specifically for no less than six quarters (18 months). Lastly, business cycles are not strictly periodic although they repeat themselves.
The literature defines two main types of business cycle: the classical cycle and the growth (or deviation) cycle. The classical cycle identifies turning points on the basis of an absolute fall or rise in the value of GDP (Sørensen & Whitta-Jacobsen, 2010). Burns and Mitchell (1946) proposed a definition in which a business cycle is a sequence of expansions and contractions of economic activity, paying a particular attention to peaks, troughs, turning points, and their timing.
The growth cycle, or the deviation cycle, defines alternating periods of expansion and contraction in macroeconomic activity with respect to deviations of the GDP growth rate from an appropriately defined trend rate of growth. According to this definition, which was initially proposed by Lucas (1980) and then refined by Kydland and Prescott (1990), the business cycle is simply the fluctuations in real GDP along the steady-state of growth.
According to the OCA theory, business cycles of countries sharing the same currency, and thus having a fixed exchange rate, should be synchronized. The reason is simple: when economic fluctuations in two or more countries are symmetric, the need for stabilization policy is also symmetric (Buti and Sapir 1998). On the other hand, when the cycle is not synchronized, the need for stabilization policies will differ among the countries. If economic fluctuations in countries within a monetary union are asynchronous, the member states will have little incentive to adopt common policies and to cooperate in the operation of the union. Having a fixed exchange rate, excludes the possibility to use monetary policy as a stabilizing instrument.