Question

With the use of appropriate diagram(s), carefully explain the theory of optimum currency areas.

Answer 1

Optimum currency area is a geographic area in which one single currency prevails for economic benefit.Each country had their own currency but Robert Mundell in 1960 opined that this will not be economically beneficial.Common currency will bring integration of capital markets and facilitate trade.But common currency has a drawback.Common currency does not allow each country to direct the intervention of fiscal and monetary policy to make their own economy stable. The first test of optimum currency area was the introduction of Euro in the European countries.While eurozone benefited from common currency , there were drawbacks as well.The Greek debt crisis was because of the common currency. Mundell said that if a country within the OCA experiences asymmetric shocks ,floating exchange rate is considered more suitable in order to deal with the negative effects of such shock . He said there are four criteria for a country to qualify as optimal currency area and enjoy the benefit of common currency and they are ,increased labor mobility in the area, capital mobility and no rigidity in price and wage across the country, there is currency risk sharing system, there will be same business cycles in the area.

Figs below show the effects of asymmetric shock on in two country A and B. In graph 1 demand shift because of the change in preference of good produced in A to good produced in B (asymmetric shock). A lower demand in A reduce quantity and price and increase unemployment.In country B the opposite will happen.