The theory of optimum currency areas (OCA) explores the conditions under which a common currency can maximize the economic efficiency of a region. It strives to identify the essential characteristics for forming a common currency zone as well as its possible costs and benefits. The research has also provided much insight into the area of optimum exchange rate management.
The phrase ‘optimum currency area’ was first coined by Mundell in 1961 in his seminal paper entitled “A Theory of Optimum Currency Areas”. Since then the theory has seen little development and the subject area has often lacked attention from economists. However, the formation of a European Monetary Union (EMU) has stimulated a resurgence of interest in the topic. (Citation)
The creation of the EMU has been an ambition of the European Union (EU) since the late 1960s. However, the timeline for achieving the EMU and a common currency was not agreed upon until the signing of the Maastricht Treaty of 1992. The treaty eliminated the national barriers to the movement of goods, labour and capital within the EU, as well as planning the creation of the euro currency and the European Central Bank. (Bean, 1992) The euro was finally adopted on the 1st Dec 1999 by eleven of the EU countries - as well as the Vatican, Andorra, Monaco and San Marino - and has subsequently been expanded further to Greece, Slovenia, Cyprus, Malta, Slovakia, Montenegro and Estonia. (Citation)
When Mundell introduced the OCA theory, the EMU was not a consideration and it was merely seen as an academic question. Mundell began by defining a currency area as “a domain within which exchange rates are fixed” and posed the prominent question “What is the appropriate domain of a currency area?”. To tackle this question he introduced the concept of regional rather than national borders for a currency area. He defined the region in terms of factor mobility, stating that a region has internal factor mobility but external factor immobility. Mundell stressed the importance for high factor of production mobility when forming an OCA. Factors of production refer to the input resources - land, labour and capital - that are required to produce goods and services. However, as land is inflexible, only capital and in particular labour are considered for factor mobility. For example, there are two regions, A and B, with high factor mobility between them. If there is a shift in demand from the products of A to the products of B then the labour and capital will also move from A to B and will not cause any significant inflationary or unemployment pressures. In this case a common currency for the two regions would be suitable. On the other hand, if there is factor immobility between the regions then the shift in demand from A to B would cause unemployment in A and inflationary pressures in B. In this situation Mundell states that two separate regional currencies would be optimal as the currency of A would appreciate relative to B to...