Journal Issue
Working Paper Summaries (WP/94/1 - WP/94/76)

Working Paper Summaries 94/42: A Formal Model of Optimum Currency Areas

International Monetary Fund
Published Date:
August 1994
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The breakup of monetary unions in the former Soviet Union, Yugoslavia, and Czechoslovakia, the reintegration of Germany into a single currency zone, and plans for European Monetary Union have all reignited interest in the characteristics of a beneficial, or optimum, currency area.

The literature on optimum currency areas was initiated by Mundell (1961) and subsequently extended by McKinnon (1963) and Kenen (1969). These three papers comprise the core theory of optimum currency areas. However, as might be expected from contributions from the 1960s, they present verbal arguments rather than formal models. This paper presents a formal model of optimum currency areas in which the world is made up of a number of different regions, each producing a different good. Each region can choose to have a separate currency or to join other regions in a larger currency union. The advantage of joining a currency union is that transactions costs with other regions in the union are lower. The disadvantage is that the exchange rate can no longer be used to offset asymmetric disturbances within the union.

The result is a flexible framework that embodies many of the criteria for optimum currency areas discussed in the literature. The model also shows that although a currency union can raise welfare of the regions within the union, it unambiguously lowers welfare for regions outside of the union. This is because the gains from the union, in the form of lower transactions costs, are limited to the members of the union, whereas losses from the union, in the form of lower output due to the interaction between the common exchange rate and rigid nominal wages, affect everybody. It must be admitted that this conclusion does depend upon some of the underlying assumptions used in the model. However, it is a useful reminder that the impact of a currency union need not be benign to those left out of its sway.

Another insight is that the incentives for a region to join a currency union are different from the incentives to admit a region into a union. The entrant gains from lower transactions costs on trade within the union, whereas the incumbent regions only gain on their trade with the potential entrant. As a result, a small region will always have a greater incentive to join a union than the union will have an incentive to admit the new member. A corollary of this is that, even if a country would prefer a free float across all regions, it may still have an incentive to join a currency union. This may explain why some countries in the European Union who are not particularly convinced of the merits of European Monetary Union (EMU) are also worried about being relegated to the second division of a two-speed EMU.

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