The theory of optimum currency area was propounded by the modern economist like Mundell, Mckinnon, Peter Kenner, Wood, etc., in recent years. This theory is an outcome of the fixed versus flexible exchange rate controversy. It offers a solution for the stabilisation policy along with, floating exchange rates in the set-up of independent monetary systems, since the fixed exchange rates oriented Bretton Wood system has failed to work satisfactorily in recent years.
The term currency area is designated to the common currency area formed by a group of countries in either of the two ways: (1) By introducing a common currency to replace all domestic currencies of the member countries, or (2) the group adopts a monetary order in which within the group a fixed exchange rate system is followed but outside the common currency area flexible exchange rate system is used for transacting with the rest of the world.
The exponent of the common currency area thus, strongly arguing for linking countries together on monetary front as by adopting a common currency the member countries in the area (or group) can eliminate the risks of floating exchange rates and consequent instability in trade and balance of payment. It is also claimed that the establishment of an optimum currency area, the goal of price stability is easily maintained in the connected economies.
It is advantageous to have larger common currency area, for the impact of a single specific disturbance will be felt least in this case. Again a larger currency area would also imply a minimisation of dependence of external trade outside the group. Hence, with other countries though, exchange rate is floating its impact would be insignificant due to relatively smaller share of trade with the outsiders.
The currency area thus protects the members from the adversities of fluctuations in prices or exchange rates in the rest of the world. Since the currency area tends to improve and maintain economic stability of the member countries it leads to an improvement in the general welfare of their citizens.
Another advantage of the common currency area is the elimination of speculative activity in foreign exchange. Travellers within the group have no botheration of collecting foreign exchange.
The question is what is an optimum currency area? It is, however, difficult to say so. Different economists held different views on this issue. Mundell, for instance, defines optimum currency area as a region in an area within which factors are mobile, so that, unemployment and balance of payments disequilibrium are automatically eliminated.
He held that, such a region should have a separate currency. Further, such a region may be larger than a country as in the European Economic Community or sometimes it may be smaller than a country, like that of Maritime Provinces of Canada.
McKinnon, however, criticised Mundell for assuming factor mobility to be the essence of the optimum currency area, as well as his insistence on the need for a closed economy in this regard. McKinnon held that the optimum currency area should be constituted by highly open economies with a greater dependence of trade. He argued that when there is an open economy which trades widely with the rest of the world it will not have any exchange illusion.
To him, “if we move across the spectrum from closed to open economies, flexible exchange rates become both less effective as a control device for external balance and more damaging to internal price-level stability.”
He shows that higher the ratio of external trade to the country’s national income, the effect of exchange rate fluctuation will tend to be greater. He, therefore, stressed that open economies should bent upon monetary and fixed policy changes and not upon exchange rate changes to attain their internal and external balance and overall economic stability. Indeed, a closed economy has to rely more upon exchange rate changes for this purpose.
Peter Kenner, on the other hand, argues that common currency areas should be formed by closed or less open but more diversified economies rather than by more open and less diversified economies.
Professor Wood, however, suggests that an optimum currency area should be determined on the basis of cost-benefit analysis. In forming the area, it is necessary that the benefits drawn by the unions must exceed the costs. If not, then the area should not be formed.
There are, however, a number of difficulties and drawbacks in forming a common currency area. The forming of such an area is not solely dependent on economic consideration. Political and institutional founders are also equally important. The political and ideological differences among different countries may obstruct the formation of a common currency area. Obviously, it is difficult to perceive a socialist country to join hand with a capitalist nation.
Another drawback of the currency area is that the member countries will not be in a position to pursue their independent monetary policy after joining the union. The members when follow a joint monetary policy it may not be optimally suitable for their specific economic situation.
Moreover, when a larger currency area is formed and even a sort of world money is introduced. it will notease the problem of liquidity. Above all, there will be a loss of political sovereignty with the joine rs which is bound to be very painful.
In short, it is apparent that the arguments for optimum currency areas, however, makes case for fixed exchange rates more stronger to save the present world from the monetary chaos.