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Optimum Currency Area Theory

Discussion in 'Forex Discussions' started by painofhell, Feb 26, 2016.

  1. painofhell

    painofhell Content Contributor

    Jun 24, 2015
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    What Is The Optimum Currency Area Theory

    The Optimum Currency Area Theory is based on a geographical area with multiple countries and currencies that adapts a single currency or a fixed exchange rate regime within its boundaries. The Optimum Currency Area refers to that geographic area in which a single currency would be creating the greatest financial benefits.

    Traditionally, each country in the world has its own national currency. However, Robert Mundell theorized in the 1960s that maintaining separate currencies for each country may not be an efficient economic arrangement. Particularly, countries that have strong economic ties would surely profit from a single currency structure. Thus, allowing closer integration of capital markets and facilitating trade. Meanwhile, the most common concern among the participating countries would be that they won’t be able to control monetary and fiscal policies individually. That, in case they need to do so in order to stabilize their economies.

    A region that has multiple countries, sharing strong economic ties, is supposed to benefit from the Optimum Currency Area Theory. By adapting to a single currency, the countries can significantly increase the amount of trade between them. However, the participating countries must consider the cost of giving up the local currencies as instruments to adjust monetary policies to be effective. Additionally, the theory also states that the participating countries should have similar economies which would help them to be integrated in the new currency region. Mundell also theorized in 1961 that the single currency of the Optimum Currency Area should maintain a flexible exchange rate system with the rest of the currencies.

    The primary test for the this Theory is the introduction of the euro in 1999 as a common currency in most of the European Union nations. The countries in the Eurozone matched well with Mundell’s criteria since they have strong economic ties, similar economies, thus providing the impetus for the creation of a common currency, the euro. Despite enjoying a lot of benefits of having a single currency, the Eurozone has experienced significant issues like the Greek debt crisis. Thus, the long-term result and benefits of monetary union under the Optimal Currency Area Theory still remains a matter of debate.

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