A Theory of Optimum Currency Areas

TL;DR: A theory of optimum currency areas is proposed in this paper, where the authors argue that periodic balance-of-payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the terms of trade from fulfilling a natural role in the adjustment process.

Abstract: It is patently obvious that periodic balance-of-payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the terms of trade from fulfilling a natural role in the adjustment process. It is, however, far easier to pose the problem and to criticize the alternatives than it is to offer constructive and feasible suggestions for the elimination of what has become an international disequilibrium system.' The present paper, unfortunately, illustrates that proposition by cautioning against the practicability, in certain cases, of the most plausible alternative: a system of national currencies connected by flexible exchange rates. A system of flexible exchange rates is usually presented, by its proponents,2 as a device whereby depreciation can take the place of unemployment when the external balance is in deficit, and appreciation can replace inflation when it is in surplus. But the question then arises whether all existing national currencies should be flexible. Should the Ghanian pound be freed to fluctuate against all currencies or ought the present sterling-area currencies remain pegged to the pound sterling? Or, supposing that the Common Market countries proceed with their plans for economic union, should these countries allow each national currency to fluctuate, or would a single currency area be preferable? The problem can be posed in a general and more revealing way by defining a currency area as a domain within which exchange rates are fixed and asking: What is the appropriate domain of a currency area? It might seem at first that the question is purely academic since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement. To this, three answers can be given: (1) Certain parts of the world are undergoing processes of economic integration and disintegration, new experiments are being made, and a conception of what constitutes an optimum currency area can clarify the meaning of these experiments. (2) Those countries, like Canada, which have experimented with flexible exchange rates are likely to face particular problems which the theory of optimum currency areas can elucidate if the national currency area does not coincide with the optimum currency area. (3) The idea can be used to illustrate certain functions of currencies which have been inadequately treated in the economic literature and which are sometimes neglected in the consideration of problems of economic policy. A Theory of Optimum Currency Areas It is patently obvious that periodic balance-of-payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the terms of trade from fulfilling a natural role in the adjustment process. It is, however, far easier to pose the problem and to criticize the alternatives than it is to offer constructive and feasible suggestions for the elimination of what has become an international disequilibrium system.' The present paper, unfortunately, illustrates that proposition by cautioning against the practicability, in certain cases, of the most plausible alternative: a system of national currencies connected by flexible exchange rates. A system of flexible exchange rates is usually presented, by its proponents,2 as a device whereby depreciation can take the place of unemployment when the external balance is in deficit, and appreciation can replace inflation when it is in surplus. But the question then arises whether all existing national currencies should be flexible. Should the Ghanian pound be freed to fluctuate against all currencies or ought the present sterling-area currencies remain pegged to the pound sterling? Or, supposing that the Common Market countries proceed with their plans for economic union, should these countries allow each national currency to fluctuate, or would a single currency area be preferable? The problem can be posed in a general and more revealing way by defining a currency area as a domain within which exchange rates are fixed and asking: What is the appropriate domain of a currency area? It might seem at first that the question is purely academic since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement. To this, three answers can be given: (1) Certain parts of the world are undergoing processes of economic integration and disintegration, new experiments are being made, and a conception of what constitutes an optimum currency area can clarify the meaning of these experiments. (2) Those countries, like Canada, which have experimented with flexible exchange rates are likely to face particular problems which the theory of optimum currency areas can elucidate if the national currency area does not coincide with the optimum currency area. (3) The idea can be used to illustrate certain functions of currencies which have been inadequately treated in the economic literature and which are sometimes neglected in the consideration of problems of economic policy.