Optimal Currency Area

An optimal currency area (OCA) is the geographic area in which a single currency would create the greatest economic benefit. While traditionally each country has maintained its own separate national currency, work by Robert Mundell in the 1960s theorized that this might not be the most efficient economic arrangement.

In particular, countries that share strong economic ties may benefit from a common currency. This allows for closer integration of capital markets and facilitates trade. However, a common currency results in a loss of each country's ability to direct fiscal and monetary policy interventions to stabilize their individual economies.

In 1961, Canadian economist Robert Mundell published his theory of the OCA with stationary expectations. He outlined the criteria necessary for a region to qualify as an OCA and benefit from a common currency.

In this model, the primary concern is that asymmetric shocks may undermine the benefit of the OCA. If large asymmetric shocks are common and the criteria for an OCA are not met, then a system of separate currencies with floating exchange rates would be more suitable in order to deal with the negative effects of such shocks within the single country experiencing them.

According to Mundell, there are four main criteria for an OCA: High labor mobility throughout the area. Easing labor mobility includes lowering administrative barriers such as visa-free travel, cultural barriers such as different languages, and institutional barriers such as restrictions on remittance of pensions or government benefits. Capital mobility and price and wage flexibility. This ensures that capital and labor will flow between countries in the OCA according to the market forces of supply and demand to distribute the impact of economic shocks. A currency risk-sharing or fiscal mechanism to share risk across countries in the OCA. This requires the transfer of money to regions experiencing economic difficulties from countries with surpluses, which may prove politically unpopular in higher-performing regions from which tax revenue will be transferred. The European sovereign debt crisis of 2009–2015 is considered evidence of the failure of the European Economic and Monetary Union (EMU) to satisfy these criteria as original EMU policy instituted a no-bailout clause, which soon became evident as unsustainable. Similar business cycles.

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