A Theory of Optimum Currency Areas
Précis by Jeff McLaren
Inflexible wages, prices and exchange rates prevent the adjustment process in which the factors of production move to a new equilibrium in response to dislocations in the economy. This situation will insure that there will be balance of payment crises. Two solutions are often posited: (1) a system of free or flexible exchange rates or (2) one universal currency. Which one is better and preferable is a serious question.
The author proposes a novel way to look a the problem: “The problem can be posed in a general and more revealing way by defining a currency area as a domain within which exchange rates are fixed and asking: What is the appropriate domain of a currency area?” The significance is that (1) at the time of publishing the article there were many experiments of the kind; (2) countries that try flexible exchange rates will encounter problems that this theory can explain. Finally (3) some roles of currencies that are not well considered by policy makers need to be high-lighted.
In a currency area that has more than one currency there will be differences in interregional adjustment and international adjustment. Consider two cases (1) a region with two countries, two currencies, a fixed exchange rate and then demand shifts from the second country's goods to the first country's goods. Faced with inflation, if the first country tries to keep prices from rising, it will induce recessionary tendencies in the second country. In other terms, the second country's unemployment will be inversely determined by the first country's tolerance for inflation.
Consider a second case (2): two regions within one country, with one currency, a full employment policy and then demand shifts from the second region's goods to the first region's goods. In this case the first region will feel greater inflation. In other words the amount of inflation in the first region is determined by the central bank's desire to effect full employment in the second region.
Two possible solutions: (1) a world wide agreement that would have all countries inflate their currencies until the last country had full employment or (2) a world central bank could allow for interregional balance payments. However neither solution would solve both unemployment and inflation therefore the optimum currency area is smaller than the whole world.
Flexible exchange rates would allow for factor balancing and would limit inflation and unemployment in all participants if and only if the economic regions are coterminous with the national borders – a fact that does not seem to be true in the world.
If we imagine two states with two regions that are not coterminous, the author shows that, a flexible exchange rate may help settle the balance of payments between the two countries but not between the two regions. There will likely be unemployment and inflation in the different regions of both countries. Therefore the problem that is supposed to be solved by flexible exchange rates remains. In such a situation it is not clear that flexible exchange rates are better than a common currency or a fixed exchange regime.
A flexible exchange regime is not necessarily out of the question. The author's argument rather suggests a currency for each region would garner the theoretical benefits of a flexible exchange regime; namely: stable and low inflation and unemployment. Therefore the optimum currency area is the region.
The region is defined as a geographical area within which factors of production are mobile but outside of which factors are not able to move. In so far as countries exhibit this property they will find a flexible exchange regime beneficial. The more regions cross international borders and/or the more multi-regional a country is; the less the benefits of flexible exchange rates will accrue to those countries.
With factor mobility as the criterion for a region two forces pushing against one another create the need for a choice in region size. (1) Factor mobility is never as absolute as national borders and therefore a region's borders will likely be in a continual state of change. If one wishes to meet the maximum levels of price stability and employment then one would push for ever greater numbers of continuously evolving regions. This would result in ever increasing transaction costs to the economy. (2) The costs can be limited if we remember that a common currency is a convenience for commerce which encourages trade and development by reducing transaction costs. A currency is therefore a limiting force on the number of optimum regions.
Two more practical reasons to limit the number of regions are: (1) too many small regions with their own currency will make it possible for large institutions to control the exchange rate to their benefit and to the peoples detriment. (2) The money illusion, in which people are not willing to tolerate a wage decline in nominal currency but are willing to do so as a result of foreign exchange rate changes, suggests that as imports grow, due to the small size of regions, the relative loss of income will become more apparent and less and less tolerable.
There are two basic questions that must be asked when considering a flexible exchange regime. The first: Can a flexible exchange regime work effectively and efficiently in the modern economic order? An affirmative answer must show that: (1) international prices can maintain a relatively stable equilibrium; (2) exchange rate fluctuations are not so great as to induce momentous changes in exports or imports; (3) a futures market can mitigate risk in the present; (4) central banks will stick to their core missions and not engage in speculation; (5) central banks will stay independent of politics especially during recessions and crises; (6) the rule of law will continue and both creditors and debtors will be protected; finally (7) remunerations are not pinned to price indexes with a heavy weight on imports.
The second question is: How should the world be divided into currency areas? In a world with a flexible exchange system each region should allow the factors of production to move as freely as possible within the region but should limit, as much as possible, factor movement in and out of the region. If in such a world, separate currencies existed in each region then the maximal benefits of a flexible exchange rate regime would be realized.
However in the real world a region is an economic classification but a currency is a political expression of sovereignty. Therefore the benefits of a floating exchange rate depend on the degree of congruity in economic regions and political jurisdictions.
Canada has been up until 1961 the only advanced country to experiment with flexible exchange rates. The author believes that it will be a failed experiment in terms of stabilization because of the high level of factor immobility in Canada which makes Canada a multi-region country. If the experiment fails it should be a warning to multi-region nations; not a strike against flexible exchange rates.
[Canada floated its dollar in 1950 but returned to a fixed exchange rate in 1962. Since June 1970 Canada has maintained its flexible exchange rate and seems to have overcome the interregional economic problems though transfer payments between provinces.]
Added on: 2009-06-26 23:59:07
Précis by: Jeff McLaren
© 2008 - 1, Jeff McLaren