The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Optimum Currency Areas

  • Masahiro Kawai
Reference work entry


An optimum currency area refers to the ‘optimum’ geographical domain having as a general means of payments either a single common currency or several currencies whose exchange values are immutably pegged to one another with unlimited convertibility for both current and capital transactions, but whose exchange rates fluctuate in unison against the rest of the world. ‘Optimum’ is defined in terms of the macroeconomic goal of maintaining internal and external balance. Internal balance is achieved at the optimal tradeoff point between inflation and unemployment (if such a tradeoff really exists), and external balance involves both intra-area and inter-area balance of payments equilibrium.

An optimum currency area refers to the ‘optimum’ geographical domain having as a general means of payments either a single common currency or several currencies whose exchange values are immutably pegged to one another with unlimited convertibility for both current and capital transactions, but whose exchange rates fluctuate in unison against the rest of the world. ‘Optimum’ is defined in terms of the macroeconomic goal of maintaining internal and external balance. Internal balance is achieved at the optimal tradeoff point between inflation and unemployment (if such a tradeoff really exists), and external balance involves both intra-area and inter-area balance of payments equilibrium.

The concept of optimum currency areas was developed in a context of the debate over the relative merits of fixed versus flexible exchange rates. Proponents of flexible exchange rates, such as Milton Friedman (1953), had argued that a country afflicted with price and wage rigidities should adopt flexible exchange rates in order to maintain both internal and external balance. Under fixed exchange rates with price and wage rigidities, any policy effort to correct international payments imbalances would produce unemployment or inflation, whereas under flexible exchange rates the induced changes in the terms of trade and real wages would eliminate payments imbalances without much of the burden of real adjustments. Such an argument in favour of flexible exchange rates left the general impression that any country must adopt flexible exchange rates irrespectively of its economic characteristics. However, countries differ in many ways. The theory of optimum currency areas claims that if a country is highly integrated with the outside world in financial transactions, factor mobility or commodity trading, fixed exchange rates may reconcile internal and external balance more efficiently than flexible exchange rates.

The pioneering work by Mundell (1961) and McKinnon (1963) (in addition to Ingram 1962), attempted to single out the most crucial economic properties to define an ‘optimum’ currency area. The subsequent work by Grubel (1970), Corden (1972), Ishiyama (1975) and Tower and Willet (1976) turned their attention to evaluating the benefits and costs of participating in a currency area. Hamada (1985) studied the welfare implications of individuals countries’ participation decisions.

Properties of an Optimum Currency Area Price and Wage Flexibility

Price and wage flexibility, or lack thereof, was the central issue in the debate over fixed versus flexible exchange rates. Indeed, the assumed price–wage inflexibility was the basis for Friedman’s argument in favour of flexible exchange rates and the later development of the optimum currency area literature. (It is appropriate to point out, however, that Friedman did not entirely dismiss the idea that a group of countries, such as the sterling area, may fix their exchange rates with one another and let the rates fluctuate jointly against the rest of the world; Friedman 1953, p. 193.)

Consider an area which is made up of a group of regions (or countries), however they may be defined. Then it can be postulated that, if prices and (real) wages are flexible throughout the area in response to the changed conditions of demand and supply, the regions in the area should be tied together by fixed exchange rates. Complete flexibility of prices and wages would achieve market clearance everywhere and facilitate instantaneous real adjustments to disturbances affecting inter-regional payments without causing unemployment. The ultimate, real adjustment consists of ‘a change in the allocation of productive resources and in the composition of the goods available for consumption and investment’ (Friedman 1953, p. 182). The required changes in relative prices and real wages accomplish such adjustment, so that inter-regional (i.e., intra-area) exchange rate flexibility becomes unnecessary. Connecting the regions by fixed exchange rates is beneficial to the area as a whole, because it enhances the usefulness of money (see section “Benefits and Costs of Currency Area Participation”). External payments balance is maintained by the joint floating of the area’s currencies against the outside world as well as by internal price–wage flexibility.

When prices and real wages are inflexible, however, the transition towards ultimate adjustment may be associated with unemployment in one region and/or inflation in another. In such an economy, exchange rate flexibility among the regions, as well as its substitutes, may partially assume the role of price–wage flexibility in the process of real adjustments to disturbances. The following measures of internal market integration have been proposed as substitutes for exchange rate flexibility so as to warrant the establishment of a currency area.

Financial Market Integration

Ingram (1962) noted the smooth way in which a high degree of internal financial integration financed inter-regional payments imbalances and eased the adjustment process within the United States, or as between the United States and Puerto Rico. This suggests that a successful currency area must be tightly integrated in financial trading.

When an inter-regional payments deficit is caused by a temporary, reversible disturbance, capital flows can be a cushion to make the real adjustment smaller or even unnecessary. When the deficit is caused by a persistent and irreversible disturbance, though financial capital flows (apart from those induced by differentials in long-run real rates of return) cannot sustain the deficit indefinitely, real adjustment is allowed to be spread out over a longer period of time. The cost of adjustment is reduced by the additional help from price–wage flexibility and internal factor mobility both of which tend to be higher in the longer run. Also financial transactions strengthen the long-term adjustment process through a different channel, i.e., wealth effects. The surplus region accumulating net claims raises expenditures and the deficit region decumulating net claims lowers them, thereby contributing to real adjustment.

Thus, financial market integration lessens the need for inter-regional (i.e., intra-area) terms-of-trade changes via exchange rate fluctuations, at least in the short run. Considering the undesirable effects that exchange rate flexibility and the associated exchange risk may have, i.e., drawing a sharp line of demarcation between ‘local’ and ‘generalized’ financial claims (Ingram 1962, p. 118) and thus separating regional financial markets, fixed exchange rates are preferred within the financially integrated area.

Factor Market Integration

Mundell (1961) argued that an optimum currency area is defined by internal factor mobility (including both inter-regional and inter-industry mobility) and external factor immobility. Internal mobility of factors of production can moderate the pressure to alter real factor prices in response to disturbances affecting demand and supply; hence the need for exchange rate variations as an instrument of real factor price change is mitigated. In this sense factor mobility is a partial substitute for price-wage flexibility, partial because factor mobility is usually low in the short run. Therefore, it is more effective in easing the cost of long-run real adjustment to persistent payments imbalances than short-run adjustment to temporary imbalances, which is minimized by financial capital mobility.

Thus, factor market integration enables the fixed exchange rate system not to interfere with the maintenance of inter-regional payments balance, while increasing the usefulness of money inside the currency area. Internal balance (the optimum inflation–unemployment tradeoff) can be secured by monetary and fiscal policy, and external balance relative to the rest of the world is achieved by the joint floating of the exchange rates.

Goods Market Integration

The apparent relative smoothness of longer-run inter-regional adjustment within the United States is often attributed to its internal openness. This suggests that a successful currency area must have a high degree of internal openness, i.e., extensive trading of products inside the area. ‘Openness’ for a given area is measured by such indicators as the ratio of tradable to nontradable goods in production or consumption, the ratio of exports plus imports to gross output, and the marginal propensity to import.

McKinnon (1963) raised the question whether an area with a certain degree of external openness should choose flexible exchange rates against other areas or join them to belong to a larger currency area. First, suppose the area is externally highly open so that tradables represent a large share of the goods produced and consumed. Then exchange rate flexibility vis à vis other areas is not effective in rectifying payments imbalances, because any exchange rate variation would be offset by price changes without significant impacts on the terms of trade and real wages. That is, the area is too small and open for expenditure-switching instruments to be potent, though wealth effects operate in the direction of restoring payments equilibrium. The by-product is an unstable general price level. Instead, the area would find it beneficial to assign expenditurereducing policy to external balance and fixed exchange rates to price stability, provided the tradable goods prices are stable in terms of the outside currency. Second, when the area is relatively closed against the rest of the world, it should peg its currency to the body of nontradable goods so as to stabilize the liquidity value of money, and assign exchange rate flexibility to external balance. Exchange rate flexibility is effective because it brings about the desired changes in the relative price of tradable goods and real wages.

Thus, the optimal monetary arrangements of an internally open, externally relatively closed economy would be to peg its currency (or currencies jointly) to the body of internally traded goods – which are viewed as nontradables from the standpoint of the outside world – for price stability, and adopt externally flexible exchange rates for external balance. Splitting such an economy into smaller regions with independently floating currencies is not desirable, nor is attaching itself to the outside world to become part of a larger currency area.

Political Integration

The analysis above demonstrates the case for a currency area when a given economy has a high degree of internal market integration for financial assets, productive resources or outputs. (Other properties such as product diversity (Kenen 1969) and similarities in tastes for inflationunemployment tradeoffs have also been proposed as ‘criteria’ for optimum currency areas.) It is obvious that the smooth functioning of a currency area system rests on absolute confidence in the permanent fixity of exchange rates and unlimited convertibility of member currencies inside the area. This will require close coordination of national monetary authorities and perhaps even the creation of a supranational central bank. Surrendering the national sovereignty over the conduct of monetary policy to a supranational authority involves not only an economic but political process as well. The recent experience of the European Monetary System indicates that, without commitment to reaching some form of political integration, managing a currency area as loose as EMS would not be easy. (EMS is a loose currency area or a ‘pseudo-exchange-rate union’ (Corden 1972) because occasional currency realignments are allowed.)

Benefits and Costs of Currency Area Participation

For a complete welfare analysis of optimum currency areas, one would, ideally, like to examine how the entire world economy should be divided into independent currency areas to maximize global welfare. But constructing a general analytical framework for such a task is almost impossible. Thus, cost-benefit analysts such as Ishiyama (1975) and Tower and Willet (1976) focused on the more restricted question whether particular countries should join with one another to form a currency area. Each country is assumed to evaluate the benefits and costs of currency area participation from a purely nationalistic point of view. The price of such a restricted approach is that a ‘nationally’ optimum currency area thus determined may not coincide with the ‘globally’ optimum currency area.


The single most important benefit a country may derive from currency area participation is that the usefulness of money is enhanced (Mundell 1961; McKinnon 1963: Kindleberger 1972; Tower and Willet 1976). Money is a social contrivance which simplifies economic calculation and accounting, economizes on acquiring and using information for transactions, and promotes the integration of markets. The use of a single common currency (or currencies rigidly pegged to one another with full convertibility) would eliminate the risk of future exchange rate fluctuations, maximize the gains from trade and specialization and, thus, enhance allocative efficiency. The usefulness of money generally rises with the size of the domain over which it is used. Money is inherently a public good.

Related to the above benefit is the fact that externalities are provided in several forms. First, currency area participation means that the participating country pegs its currency to the class of representative goods in the area. Hence, a financially unstable country can enjoy a high liquidity value of money by joining in a more financially prudent currency area. Secondly, a financially well-integrated currency area offers the domain of risk-sharing. An inter-regional payments imbalance is immediately accommodated by a flow of financial transactions, which enable the deficit country to draw on the resources of the surplus country until the adjustment cost is efficiently spread out over time. (There are other benefits arising from currency area participation, such as the reduction of official reserves and the elimination of speculative capital flows.)


The system of flexible exchange rates, in principle, allows each country to retain monetary independence. However, the system of fixed exchange rates requires unified or closely coordinated monetary policy, constraining the participating countries’ freedom to pursue independent monetary policy. This loss of monetary independence is considered the major cost of currency area participation, since it may force the member countries to depart from internal balance for the sake of external balance. The cost is deemed large if the country has a low tolerance for unemployment and is subject to strong price and wage pressures from monopolistic industries, labour unions and long-term contracts. On the other hand the cost may be small if it faces a relatively vertical Phillips curve (as in the case of a small, highly open economy), because in such a case the country would not have much freedom to choose the best inflation unemployment tradeoff in the first place.

Calculus of Participation

Currency area formation is a dynamic process. In the process towards more complete monetary integration, public confidence in the system will grow, some new benefits may emerge, the existing benefits may rise, and the costs may diminish. Thus, intertemporal balancing of the benefits against the costs is necessary. It can be postulated, therefore, that an individual country will decide to participate in a currency area if the expected (discounted value of future) benefit exceeds the expected (discounted value of future) cost.

Two remarks must be made in this calculus of participation. First, the country is assumed to compare two extreme exchange rate regimes, i.e., irrevocably fixed exchange rates and freely flexible exchange rates. However, from the viewpoints of maximizing national welfare (namely benefits minus costs), there will almost always be an optimal exchange market intervention strategy that allows some exchange rate flexibility and some changes in external reserves, and the polar cases of fixed and flexible exchange rates are unlikely to be optimal – see for example Boyer (1978), Roper and Turnovsky (1980) and Aizenman and Frenkel (1985).

Second, each country chooses the best exchange rate arrangement on the assumption that its choice and policy would not affect the rest of the world, though it may condition its actions on the policies pursued by other countries. As a result, the ‘optimum’ currency area thus determined may not be ‘globally’ optimum. As is emphasized by Hamada (1985), when the important benefits of currency area formation exhibit public-good characters and externalities and the costs are borne by individual countries, the rational theory of collective action (e.g., Buchanan 1969) suggests that individual countries’ participation decisions tend to produce a currency area that is smaller than is ‘socially’ optimum. (However, if the public-bad character of the costs dominates the public-good character of the benefits, the resulting currency area based on individual calculations may well be larger than is globally optimum.) The proposed calculus of participation obviously neglects the possible strategic interactions among countries; there is no leader–follower relationship and no cooperation. The game-theoretic approach to optimal exchange rate arrangements has recently attracted economists’ attention – see Hamada (1985), Canzoneri and Gray (1985) and papers in Buiter and Marston (1985).

What Have We Learned?

Several issues have been made clear in the course of the development of the optimum currency area literature and its cost–benefit application.

First, the choice of a flexible or fixed exchange rate regime is understood as one of secondbest solutions to friction-ridden economies (Komiya 1971). If the markets for outputs, factors of production and financial assets were completely integrated on a worldwide scale, relative prices and real wages were perfectly flexible, and economic nationalism (which attempts to insulate a national economy from the rest of the world by way of artificial impediments to trade, capital flows and foreign exchange transactions) were absent, then the optimum currency area would be the whole world. In such a case, the real adjustment to payments imbalances would be extremely smooth, factor resources would be always fully employed, and the usefulness of money would be maximized. However, to the extent that the payments adjustment mechanism is impaired by market fragmentation and price–wage rigidities, a country may adopt flexible exchange rates as a second-best policy to attain internal and external balance. The optimum currency area literature has shown that measures of market integration (for financial assets, factor resources and goods) may partially, and more effectively, substitute the required role of price–wage flexibility than does exchange rate flexibility.

Second, the cost–benefit approach to optimum currency areas based on purely national interest is limited in the analysis of designing an optimum international monetary system. Given the degree of spillover effects and economic interdependence among closely integrated countries, the strategic behaviour on the part of national policy-makers must be explicitly incorporated in order to deepen our understanding of the nature of ‘globally’ optimum currency areas and optimal international monetary arrangements.

As a final note it is interesting to observe that the two economists who advanced the theory of optimum currency areas, Mundell and McKinnon, now support fixed exchange rates. Mundell has been advocating a worldwide gold standard system and McKinnon (1984) a fixing of the exchange rates among three major industrialized countries (USA, West Germany and Japan). Thus they regard the world as a whole or the industrial core of western society as capable of establishing a currency area.

See Also


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© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Masahiro Kawai
    • 1
  1. 1.