Optimum currency area theory: A selective review

The first part of this paper is a review of significant papers in the vast literature on optimum currency area (OCA) theory. The author focuses on the main classical contributions, then considers modern treatment of OCA theory. The second part considers empirical literature on the types of geographical areas that might constitute optimum currency areas, particularly with respect to asymmetry and symmetry of shocks.

Introduction: Optimal currency area (OCA) theory deals with complicated, inter-mingled issues at the core of international macroeconomics. OCA theory’s main applications are found, to my best knowledge, in three areas. First, OCA theory has reshaped the discussion on selection of an exchange rate regime for a given country. Although the criteria developed under OCA theory are not easily put into practice, the substantial literature on selecting exchange rate regimes well documents the rise to prominence of OCA theory in the analysis used in selection of an exchange rate regime. Second, OCA theory provides considerable insight into the role of exchange rate adjustment under balance of payment disequilibria. The extensive empirical literature on measuring the symmetry and asymmetry of shocks to countries and regions well documents this impact. Third, OCA theory has contributed to the theory of monetary integration and has been fundamental in the design of Europe’s Economic and Monetary Union (EMU). It also provides a standard point of departure in discussions of dollarization and creation of new monetary unions.

Author: Julius Horvath

Source: Institute for Economies in Transition, Bank of Finland

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