Optimum%20Currency%20Areas - The Theory of Optimum Currency...

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Unformatted text preview: The Theory of Optimum Currency Areas Max Milbredt * January 27, 2008 Abstract This paper reviews the developments and some of the empirics of the Theory of Optimum Currency Areas. It emphasizes the foundations of the Theory and its application to the Euro- pean Monetary Union. * MA Student, Department of Economics, Queens University, Kingston, Ontario, Canada. Email: mil- bredt@econ.queensu.ca. I would like to thank Dave Babin for helpful comments and suggestions. 1. Introduction The Theory of Optimum Currency Areas (OCA) was developed in the early 1960s and has subsequently been expanded. It attempts to answer the question under which circum- stances it is beneficiary for a country or region to constitute a common currency area with other countries or regions. Interest in its results and implications has recently renewed par- ticularly because of the European Monetary Union (EMU) and its possible expansion from the current 16 member states to 25 or beyond. But the EMU is merely the most prominent example of a supranational currency union, other examples include the East Caribbean Dollar for a number of smaller Caribbean states and the CFA Franc for a number of West African countries. However, it is also disputed whether or not the Theory of OCA is relevant to the question that was posed to it after all. The remainder of the paper is structured as follows: Section 2 will examine what is con- sidered the most fundamental paper in the theory of Optimum Currency Areas, a work by Robert A. Mundell. In Section 3, the more recent developments of the theory are presented while Section 4 examines the question of whether or not the European Monetary Union (EMU) can be considered an optimum currency area or not. Section 5 concludes. 2. Mundells groundwork A currency union can be interpreted as a system of non-changeable fixed exchange rates between two entities. So the question of the optimum currency area is a matter of which areas should prefer unalterable fixed exchange rates and which areas should prefer floating exchange rates and with whom. Mundell argues that there are essentially two issues constituting this question: Firstly, having different currencies causes, amongst other things, transaction costs. The extreme ex- ample is the case of an economy where every person has their own money, or the economy 1 relies on barter. This is generally viewed as not beneficial for any economy. The more curren- cies that exist, the more money will have to be exchanged in order to trade with others, thus increasing transaction costs. Also, the smaller the currency areas are, the more vulnerable each area becomes to speculation with its currency. If only transaction costs and speculationeach area becomes to speculation with its currency....
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Optimum%20Currency%20Areas - The Theory of Optimum Currency...

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