Optimal Currency Area

Optimal Currency Area

In the post–World War II era economists raised the issue of the optimal currency area, which is that area that stands to gain from an independent currency. The issue grew in importance as Europe made plans to establish an all-European currency, the euro, to replace individual national currencies such as the German mark, French franc, and Swiss franc. Although Europe is merging into one large currency area, the breakup of the Soviet Union has held out the spectacle of a large currency area splintering into smaller currency areas, as new nations such as Ukraine replaced rubles with their own currency.

One theory of optimal currency areas emphasizes the importance of resource immobility. Consider two areas, one with a high unemployment rate and another with a low unemployment rate. If labor is a mobile resource, the unemployed workers will migrate to the area with the low unemployment rate. If labor is not mobile, due to distance, national laws, or language differences, then differences in currency exchange rates between the two geographical areas can serve some of the same purpose, assuming the two areas have their own separate currencies. The area with high unemployment can lower the value of its currency, making its exports cheaper to the area with low unemployment. Also, the lowered currency value will increase the cost of imports to the high-unemployment area, encouraging domestic consumers to buy locally produced goods. Therefore, adjustments in the exchange rate will increase the demand for goods produced in the high-unemployment area, and lower the demand for goods produced in the low-unemployment area, indicating that areas with immobile resources should have their own currency. According to this criterion, Canada is probably too large to have a single currency because of the vast distance between the east coast and west coast, making mobility difficult. Among members of the European Union, reductions in barriers restricting the flow of capital and labor between countries preceded the introduction of the euro in 1999.

Another theory of optimal currency areas looks at the importance of internal trade relative to trade with outsiders. In the case of Europe, this theory looks at the size of trade between European countries, such as France and Germany, relative to the size of trade between Europe as a whole and outsiders, such as the United States. An area that trades a great deal with itself, and not so much with the rest of the world, should qualify as an optimal currency area, and have its own currency. Under this criterion, Canada again would not constitute an optimal currency area if regions in Canada traded largely with the United States, rather than with other regions in Canada. If regions in Canada trade mostly with other Canadian regions, then Canada benefits from having its own currency. This criterion leaves the case of Europe somewhat in limbo, because Europe trades significantly within itself, but also trades significantly with outsiders.

Another criterion for an optimal currency area is that the area must have institutions that can make political and technical decisions for the area as a whole. Nation states are the most obvious currency areas for this reason. Canada obviously qualifies as an optimal currency area under this criterion. Europe has moved toward political integration, including the election of a European Parliament, making Europe much more suitable as an optimal currency area.