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Reconsidering the theories of optimum currency area - a critique
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Reconsidering the theories of optimum currency area - a critique

25 pages · 3.90 EUR
(October 2007)

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1. Does optimum currency area theory still hold true? When Robert Mundell wrote his pathbreaking eight-page-essay on ?A theory of optimum currency areas? in 1961, he triggered a never-ending wave of publications on this theme (cp. the overviews in Kawai 1987 and Demirbas 2002). He invented both a theory and a question, in fact more than one. His main interest seems to have been to pinpoint the conditions as to when fixed exchange rates are justified, when the intention is to conduct an effective common monetary policy for all parts of the ?region?.

The second question concerned the applicability to different economies using only one currency. He not only contributed to the longstanding debate about flexible and fixed exchange rates but also to the ?optimal? size of a currency area comprising several economies and states. His early answer was clear ? optimum currency areas are small; there is seldom a case for monetary unions. Many followers found the questions he posed interesting, but by adjusting them slightly, different answers implied strong contrasts. Many found his early theory flawed and considered it a failure (cp. an early review: Feldsieper 1988); for others it became the conventional wisdom of international economics. Quite a few of Mundell?s successors called for the possibility of wider currency areas, as did the creator himself in the 1970s and later. Over the years, the many twists and turns have culminated in a variety of contrasting theories.

It was mainly the progressing European integration that kept the interest in the old theory, but the failure of the Werner Plan (1970), the early attempt towards a European monetary union, made the theory appear ostensibly dead. Ironically, when the European monetary union finally did materialise, most observers regarded it as a non-optimum currency area according to Mundell?s (1961) criteria. Furthermore, in structural terms the architecture of the European Union even stipulates the entry of strongly divergent economies to the EMU contradicting the 1961 criteria. Alongside European monetary integration, the vagaries of the unstable global currency system, based on more or less floating exchange rates after the demise of the Bretton-Woods system, renewed the interest of developing countries in regional monetary cooperation, in currency boards and in dollarisation. The alternatives to an optimum currency area (OCA) are the use of exchange rates, but what is the appropriate exchange rate regime (cp. Driver et al. 2005)? Floating exchange rates implicate numerous problems, especially for small open economies severely indebted in hard currency. Flexible exchange rates have turned out to be much more volatile as compared to what most pro-flexible-rates economists believed at that time. Today, after the experience of volatile exchange rates and so many currency crises in emerging economies, Mundell?s early questions are still valid and more acute than ever before. Indeed, it seems that the issues are more relevant now than Mundell?s first answer, which in retrospect proves to be a much too narrow approach. The need for a robust OCA theory as a guideline for monetary cooperation (cp. as a primer on this subject Priewe 2006) has not yet been satisfied.

In the following, I will take stock of the old theory, its rise and fall and its various turns. I attempt to track down tentative answers to four questions:

(i) Can we draw on a robust modern theory of OCA when talking about regional integration?

(ii) What is an OCA as compared to a currency (or monetary) union? What is an ?area? in this context?

(iii) How much real convergence does a monetary union require?

(iv) Does an OCA, even more so a monetary union, need a common state and thus political unification?

This paper proceeds as follows: Part 2 analyses the evolution of OCA theories by discussing some representative contributions; part 3 summarises the criticisms in five points; part 4 concludes.

quotable essay from ...
European Integration in Crisis
Eckhard Hein, Jan Priewe, Achim Truger (eds.):
European Integration in Crisis
the author
Prof. Dr. Jan Priewe
Jan Priewe

Professor für Volkswirtschaftslehre an der Hochschule für Technik und Wirtschaft Berlin.

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