Optimum currency area, Microeconomics

Optimum currency area:

An optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. It describes the optimal characteristics for the merger of currencies or the creation of a new currency. An optimal currency area may often be larger than a country. For instance, part of the rationale behind the creation of the euro was that the individual countries of Europe did not each form an optimal currency area, but that Europe as a whole does form an optimal currency area.

The main characteristics of an optimum currency area are:
1) Labour should have free mobility across the region. This includes physical ability to travel (visas, worker's rights, etc.), lack of cultural barriers to free movement (such as different languages) and institutional arrangements (such as the ability to have pension transferred and to the new region).

2) Openness with capital mobility and price and wage flexibility across the region. This is so that the market forces of demand and supply automatically distribute money and goods to where they are needed. In practice this does not work perfectly as there is no true wage flexibility.

There should be an automatic fiscal transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics. This usually takes the form of taxation redistribution to less developed areas of a country/region. This policy, though theoretically accepted, is politically difficult to implement as the better-off regions rarely give up their revenue easily.
Additional criteria that have been suggested for a region to be called an OCA by some economists are: there should be (a) production diversification (b) homogeneous preferences and (c) commonality of objectives The classical case for optimum currency areas assumes not only a similarity among participating countries, but also a high level of economic integration among participating countries. This theory has been most frequently applied in recent years to the euro and the European Union. 

By the above criteria the European Union does not constitute an Optimal Currency Area and therefore the Euro should not be a successful union of currencies. Although the developing world's experience with monetary unions has been neither abundant nor successful, European monetary integration has led to some initiatives for forming monetary unions in the developing world. The initiative taken by the members of the Gulf Cooperation Council stands out in this regard.

Posted Date: 11/9/2012 7:01:02 AM | Location : United States

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