What Is Optimum Currency Area (OCA) Theory?
Optimum currency area theory (OCA) states that specific areas not bounded by national borders would benefit from a common currency. In other words, geographic regions may be better off using the same currency instead of each country within that geographic region using its own currency.
Key Takeaways
- Optimum currency area (OCA) theory states that regions that are not bounded by national borders and share certain traits should share a common currency.
- OCA theory was developed in 1961 by Canadian economist Robert Mundell based on earlier work by Abba Lerner.
- OCA theory posits that implementing currencies by geographic and geopolitical region, instead of by country, leads to greater economic efficiency.
- An OCA must meet four criteria to qualify, and some economists suggest a fifth.
Understanding Optimum Currency Area (OCA) Theory
Sharing a currency can benefit a geographic region by significantly increasing trade. However, this trade must outweigh the costs of each country giving up a national currency as an instrument to adjust monetary policy. Areas using OCA theory can still maintain a flexible exchange rate system with the rest of the world.
OCA theory was developed in 1961 by Canadian economist Robert Mundell based on earlier work by Abba Lerner. It speculates that there is an optimum geopolitical area that should share a currency, but this geopolitical area doesn’t necessarily correspond with national borders. An optimum currency area could be several nations, parts of several nations, or regions inside a single nation.
According to the theory, a common currency can maximize economic efficiency, provided that the participants meet the following four criteria:
- A large, available, and integrated labor market that allows workers to move freely throughout the area and smooth out unemployment in any single zone.
- The flexibility of pricing and wages, along with the mobility of capital, to eliminate regional trade imbalances.
- A centralized budget or control to redistribute wealth to parts of the area that suffer due to labor and capital mobility. This is a politically difficult one, as wealthy parts of the region may not wish to distribute their surpluses to those that are lacking.
- The participating regions have similar business cycles and timing for economic data to avoid a shock in any one area.
Princeton professor and international economist Peter Kenen suggested the addition of a fifth criterion of production diversification within the geopolitical area.
The U.S. As an Optimum Currency Area
Some economists argue that the United States should be divided into several smaller currency areas, as the country as a whole does not fit the criteria listed in Mundell’s original OCA theory. Economists have calculated that the Southeast and Southwest regions of the United States do not necessarily fit with the rest of the country as an OCA.
Example of the OCA Theory
Many point to the euro as proof of OCA theory in action; however, some argue that the area did not meet the four criteria as laid out by Mundell’s theory at the time of the euro’s creation in 1999. This lack of meeting the requirements, they say, is the reason the eurozone has struggled since its inception.
Indeed, the OCA theory was put to the test in 2010 as sovereign debt issues faced by many heavily indebted nations in Europe threatened the viability of the European Union (EU), placing severe strains upon the euro.
According to Global Financial Integrity, a non-profit located in Washington, D.C., peripheral EU countries such as Portugal, Italy, Ireland, Greece, and Spain (PIIGS) experienced slowing growth, lacked international competitiveness, and possessed a labor force that was unproductive.
As these economies slowed, private capital fled, some to stronger eurozone economies, and some to other countries. Also, due to language, culture, and distance difficulties, the labor force in the eurozone is not fluid or mobile. Wages are not uniform across the geopolitical area, either.
Is Europe an Optimal Currency Area?
Technically, Europe is not an optimal currency area because the countries are not well integrated enough to be so. Despite this, many countries in Europe operate under one currency, the euro, which turned out to be a burden for some countries during the eurozone crisis during the Great Recession.
Is the U.S. an Optimal Currency Area?
Not as a whole, but regionally, yes, the U.S. is an optimal currency area. Though the U.S. is one country and utilizes one currency, some regions are specifically integrated enough that the U.S. could use different currencies in these regions for optimization. These regions have similar business cycles and would respond similarly to economic issues.
What Are the Benefits of an Optimum Currency Area?
Some of the benefits of an optimum currency area include the removal of uncertainty through shifting exchange rates; increased flow of trade amongst member countries; specialization in production; stability in prices, and a reduction in costs.
The Bottom Line
The optimum currency area (OCA) theory believes that countries within a certain geographic region would be better served using the same currency rather than their own individual currencies. This has been implemented, for example in Europe with the euro. However, many economists state how the euro did not meet the criteria of the theory and, therefore, is partly why it has struggled from time to time.
