A Theory of Optimum Currency Areas

Mundell poses a deceptively simple question: if a currency area is defined as “a domain within which exchange rates are fixed,” what is the right size for one? Starting from a stylized two-entity model of a demand shift between regions with sticky wages and prices, he shows that a world of many national currencies connected by flexible exchange rates can correct the balance of payments between countries but leaves unemployment and inflation unresolved whenever the regions actually hit by a demand shift cut across national borders – while a single common-currency area, conversely, imparts either an inflationary bias (if pursuing full employment) or a recessive tendency (if restraining inflation) across all its regions simultaneously. His proposed resolution is that the flexible-exchange-rate argument is valid only when currency areas are drawn along the lines of actual factor mobility – defining a region as “within which there is factor mobility, but between which there is factor immobility” – so that the optimum currency area is the region, not the nation-state, with each such region floating against all others. Mundell immediately qualifies this conclusion, however: unlimited “Balkanization” into ever-smaller regional currencies is checked by the rising transaction and information costs of using many monies, by the risk that very thin foreign-exchange markets could be moved by a single speculator, and by the implausibility of the “money illusion” that wage bargainers would need in very small, import-dependent currency areas. The paper, written while the European Common Market’s path toward integration and Canada’s then-recent experiment with a floating exchange rate were live policy questions, became the founding statement of optimum-currency-area theory and remains the reference point against which later criteria (openness, diversification, fiscal integration) are measured.

Robert A. Mundell | Macro Paper Warehouse

A Theory of Optimum Currency Areas