A Theory of Optimum Currency Areas

Mundell opens by stating 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,” but immediately cautions that the paper will illustrate the limits of “the most plausible alternative: a system of national currencies connected by flexible exchange rates.” He frames the central question operationally: defining a currency area as “a domain within which exchange rates are fixed,” what is “the appropriate domain of a currency area?” He justifies treating what might seem a purely academic question (since abandoning national currencies seemed politically infeasible) on three grounds: ongoing experiments in economic integration and disintegration (for which a theory of optimum currency areas can clarify what is being attempted), the particular problems facing countries like Canada that had experimented with flexible rates when the national currency area does not coincide with the optimum one, and the paper’s use in illustrating neglected functions of currencies (Introduction).

Mundell argues that a single currency implies a single central bank with an elastic supply of interregional payments, whereas a currency area of more than one currency requires the cooperation of multiple central banks, since “no central bank can expand its own liabilities much faster than other central banks without losing reserves and impairing convertibility” – creating “a major difference between adjustment within a currency area which has a single currency and a currency area involving more than one currency.” Using a two-entity model (regions or countries) with sticky wages and prices and a demand shift from entity B’s goods to entity A’s, he shows that under national currencies and fixed exchange rates, if surplus country A restrains its own inflation, “all the burden of adjustment is thrust onto country B,” which must contract output and employment since it cannot lower prices and A will not raise them – so that “the policy of surplus countries in restraining prices… imparts a recessive tendency to the world economy” under a currency area with many separate currencies (Section I).

Under a common currency with a government pursuing full employment, the same demand shift from region B to region A causes unemployment in B and inflationary pressure plus a balance-of-payments surplus in A; correcting B’s unemployment via monetary expansion “aggravates inflationary pressure in region A,” because the main channel by which monetary policy restores full employment in the deficit region is “by raising prices in the surplus region, turning the terms of trade against B” – so “full employment thus imparts an inflationary bias to the multiregional economy… [with a] common currency.” Mundell summarizes the resulting asymmetry sharply: in a national-currency area, the pace of employment in deficit countries is set by surplus countries’ willingness to inflate; in a common-currency area, the pace of inflation is set by the willingness of central authorities to tolerate unemployment in deficit regions. Neither regime can escape both problems at once, and Mundell concludes that “the fault lies not with the type of currency area, but with the domain of the currency area. The optimum currency area is not the world” (Section I).

Mundell constructs a deliberately provocative example: a two-country world (Canada, United States) whose national exchange rate floats, but in which the real economic regions – an “East” producing cars and a “West” producing lumber – cut across the national border. A productivity increase in autos shifting demand toward lumber causes unemployment in the East and inflation in the West; critically, “the flexible exchange rate system does not serve to correct the balance-of-payments situation between the two regions (which is the essential problem) although it will do so between the two countries.” Even with the Canada-U.S. rate freely floating, both countries still face the choice between accepting unemployment in the East, inflation in the West, or sharing the burden between the two – “both unemployment and inflation cannot be escaped” – because exchange-rate flexibility only ever operates at the national border, not at the boundary of the region actually experiencing the shock (Section II).

Mundell’s resolution is to abandon national currencies as the relevant unit and instead propose regional currencies: if “Eastern” and “Western” dollars replaced the Canadian and U.S. dollars, with the East-West rate flexible, “an excess demand for lumber products need cause neither inflation nor unemployment in either region,” since the Western dollar simply appreciates to clear the imbalance while each region’s central bank stabilizes its own regional price level and employment. He reinforces this with an analogy to the interwar gold-standard critique: if the gold standard’s harsh discipline and transmission of depressions across countries was a valid criticism, “then why should a similar argument not apply against a common currency system in a multiregional country?” since depression would likewise transmit between regions sharing a common currency. His formal conclusion: “if the case for flexible exchange rates is a strong one, it is, in logic, a case for flexible exchange rates based on regional currencies, not on national currencies. The optimum currency area is the region” – with a region defined, in the paper’s own footnoted sense, as “areas within which there is factor mobility, but between which there is factor immobility” (Sections II-III).

Mundell observes that the theory of international trade was built on the Ricardian assumption that factors of production are internally mobile but internationally immobile, an assumption economists including Williams, Ohlin, and Iversen had already challenged for real trade theory; he argues its relaxation “has important consequences also for the monetary theory of trade and especially the theory of flexible exchange rates.” The argument for national-currency flexible rates, he states, “is only as valid as the Ricardian assumption about factor mobility” – it works well if factor mobility is high within nations and low between them, but fails once regions cut across national boundaries or nations are themselves multiregional, in which case the case for flexible rates is “only valid if currencies are reorganized on a regional basis” (Section IV).

Mundell applies the optimum-currency-area concept to the Common Market debate, contrasting J. E. Meade’s position – that conditions for a common European currency do not exist, especially given the lack of labor mobility, so flexible rates would better preserve balance-of-payments equilibrium and internal stability – with Tibor Scitovsky’s view that a common currency would itself induce greater capital mobility, provided steps are also taken to improve labor mobility and coordinate employment policy. Mundell argues the apparent disagreement “reduces to an empirical rather than a theoretical question”: both writers implicitly agree that high factor mobility is the essential ingredient for either a common currency or a single currency area, differing only on whether that mobility already exists (Meade) or could be induced by the currency union itself (Scitovsky) – so the real question is simply “whether or not Western Europe can be considered a single region,” which Mundell explicitly calls “essentially an empirical problem” the paper does not resolve (Section IV).

Mundell acknowledges the dilemma directly: since factor mobility is a matter of degree that could in principle justify treating “every minor pocket of unemployment arising from labor immobility as a separate region,” rigid pursuit of internal stability alone would seem to favor an arbitrarily large number of currency areas – a conclusion he says “hardly appeals to common sense.” He identifies three countervailing forces that check this “Balkanization”: first, the pure convenience value of money as a unit of account and medium of exchange falls as the number of currencies rises, since (quoting John Stuart Mill) nations “choose to assert their nationality by having, to their own inconvenience and that of their neighbours, a peculiar currency of their own,” and in the limiting case where the number of currencies equaled the number of commodities, “the usefulness of money in its roles of unit of account and medium of exchange would disappear, and trade might just as well be conducted in terms of pure barter”; second, foreign-exchange markets “must not be so thin that any single speculator (perhaps excepting central banks) can affect the market price,” which smaller currency areas risk; and third, the flexible-rate argument implicitly assumes workers bargain for money wages with some tolerance for real-income changes via the exchange rate (a degree of “money illusion”), an assumption that “becomes increasingly unlikely” as currency areas shrink and the import share of consumption rises, since “the necessary degree of money illusion becomes greater the smaller are currency areas” (Section V).

In the concluding section, Mundell is explicit that he has not addressed a separate, prior question: whether flexible exchange rates can “work effectively and efficiently in the modern world economy” at all. He lists seven conditions this would require, including dynamic stability of the exchange-rate system once speculative demands are taken into account, exchange-rate movements not so large as to cause disruptive shifts between export- and import-competing industries, affordable forward-market cover for exchange risk, central banks refraining from monopolistic speculation, political constraints maintaining monetary discipline, reasonable protection for international creditors and debtors, and wages/profits not overly tied to import-heavy price indices – stating plainly, “I have not explicitly discussed these issues in my paper.” The paper’s own contribution is confined to the second, distinct question: given that flexible rates work, how should the world be divided into currency areas (Section VI).

Mundell treats Canada as “the only modern example where an advanced country has experimented with flexible exchange rates” and predicts, on the logic of his own argument, that the experiment “should be largely unsuccessful as far as stabilization is concerned,” because of factor immobility between Canadian regions: a rise in foreign demand for one region’s products would appreciate the national exchange rate and increase unemployment in the remaining regions, a problem that national monetary policy could only address by aggravating inflation in the favored region. He adds a second, distinct channel: high external capital mobility interferes with stabilization because the exchange rate, not the interest rate, carries the stabilizing adjustment, which “conduces to a cyclical approach to equilibrium.” He is careful to scope this claim: “a failure of the Canadian experiment would cast doubt only on the effectiveness of a flexible exchange system in a multiregional country, not on a flexible exchange system in a unitary country” (Section VI).