The theory of optimum currency areas (OCA) was first published by Robert Mundell in 1961. It shows that countries could join a monetary union if the costs of doing so are lower than the benefits.
Basically, a monetary union is an irrevocable fixed exchange rate system. Mundell defines the absence of the exchange rate mechanism as the cost of monetary unions. For example, normally countries in economic trouble could devalue their currency and, in turn, increase exports.
Within a monetary union, this adjustment is no longer feasible because no single country can influence the currency. However, the benefits of a monetary union include the gains of increasing trade between the involved countries, because trade is no longer hampered by rapid changes of exchange rates.
The theory predicts that the benefits of a monetary union will outperform its cost only if the transfer of capital and labour is high between the countries joining the union. For example, if there is a crisis in one country, labour and capital could freely move to countries with better economic performance and therefore prevent unemployment.
Consequently, within a monetary union, the adjustment of exchange rates has to be replaced by the adjustment of labour and capital.
The European Monetary Union (EMU), founded in 1999, is the most prominent example of the OCA theory.
However, somewhat curiously, the Maastricht criteria, which countries have to satisfy in order to join the EMU, are totally unrelated to the OCA criteria. The current sovereign debt crisis in the Euro area is perhaps one outcome of this deficiency.
For example, there is still no free transfer of labour and capital between the countries of the EMU, which could have substituted for the absence of the exchange rate mechanism.
Consequently, the troubled countries could either suffer high unemployment for a long time or leave the union. Once they leave, they are free to devalue their currency and therefore simulate exports and their economy.
The theory requires a coordinated fiscal policy of the national governments within the monetary union with regards to spending and taxation in order to balance the impact of the unified monetary policy, that is one interest rate for all countries, despite different economic situations in each country.
In a monetary union, with its single currency, there can only be one monetary policy or one interest rate. Such situations are especially painful if, like the EMU, no joint fiscal policy exists that could compensate for the lack of different monetary policies.
Nevertheless, recent studies have shown that the increasing intensity of trade within the EMU had a positive effect on business cycle synchronisation between the countries. That means a boom in one country triggers a boom in another country as well. But, of course, the same is true for a downturn in the business cycle.
However, situations where some countries are booming and others are not – so-called ‘asymmetric shocks’ – are more dangerous for a monetary union (MU) because this requires different monetary policies, an option no longer available within an MU. For example, countries that are not experiencing a boom will find it difficult to recover as it does not have its own policy to manage its money supply and set interest rates.