What Is an Optimal Currency Area (OCA)?

An optimal currency area (OCA) is the geographic area in which a singlecurrency would create the greatest economic benefit. While traditionally each country has maintained its own separatenational currency, work by Robert Mundell in the 1960s theorized that this might not be the most efficient economic arrangement.

In particular, countries that share strong economic ties may benefit from acommon currency. This allows for closer integration ofcapital markets and facilitates trade. However, a common currency results in a loss of each country's ability to direct fiscal and monetary policy interventions to stabilize their individual economies.

Deep Dive into Optimal Currency Areas (OCAs)

In 1961, Canadian economist Robert Mundell published his theory of the OCA with stationary expectations. He outlined the criteria necessary for a region to qualify as an OCA and benefit from a common currency.

In this model, the primary concern is that asymmetric shocks may undermine the benefit of the OCA. If large asymmetric shocks are common and the criteria for an OCA are not met, then a system of separate currencies withfloating exchange rates would be more suitable in order to deal with the negative effects of such shocks within the single country experiencing them.

Key Criteria of an Optimal Currency Area (OCA)

According to Mundell, there are four main criteria for an OCA:

• High labor mobility throughout the area. Easing labor mobility includes lowering administrative barriers such as visa-free travel, cultural barriers such as different languages, and institutional barriers such as restrictions on remittance ofpensions or government benefits.
• Capital mobility and price and wage flexibility. This ensures that capital and labor will flow between countries in the OCA according to the market forces ofsupply and demand to distribute the impact of economic shocks.
• Acurrency risk-sharing or fiscal mechanism to share risk across countries in the OCA. This requires the transfer of money to regions experiencing economic difficulties from countries withsurpluses, which may prove politically unpopular in higher-performing regions from which tax revenue will be transferred. TheEuropean sovereign debt crisis of 2009–2015 is considered evidence of the failure of the European Economic and Monetary Union (EMU) to satisfy these criteria as original EMU policy instituted a no-bailout clause, which soon became evident as unsustainable.
• Similarbusiness cycles. Cyclical ups and downs that are synchronous, or at least highly correlated, across countries in the OCA are necessary since the OCA’scentral bank will by definition be implementing a uniform monetary policy across the OCA to offset economic recessions and containinflation. Asynchronous cycles would unavoidably mean that a uniform monetary policy will end up being counter-cyclical for some countries and pro-cyclical in others.

Other criteria have been suggested by later economic research:

• A highvolume of trade between countries implies that there will be correspondingly high gains from the adoption of a common currency in an OCA. However, a high volume of trade can also suggest largecomparative advantages andhome market effects between countries, either of which can lead to heavily specialized industries between countries. 
• More diversified production within economies and limited specialization and division of labor across countries reduce the likelihood of asymmetric economic shocks. Countries that are heavily specialized in certain goods that other countries do not produce will be vulnerable to asymmetric economic shocks in those industries, and might not be suitable for membership in the OCA. Note that this criteria can come into conflict with some of the above criteria because the greater the degree of integration among countries' economies (mobility of goods, labor, and capital) the more they will tend to specialize in different industries.
• Homogeneous policy preferences across countries in the OCA are important becausemonetary policy, and to some extent fiscal policy in the form of transfers, will be a collective decision and responsibility of the countries in the OCA. Major differences in local preferences for how to respond to either symmetric or asymmetric shocks can undermine cooperation and political will to join or remain in the OCA. 

The Eurozone and Debt Crises' Impact on OCAs

The OCA theory had its primary test with the introduction of theeuro as a common currency across European nations.Eurozone countries matched some of Mundell's criteria for successful monetary union, providing the impetus for the introduction of a common currency. While the eurozone has seen many benefits from the introduction of the euro, it has also experienced problems such as the Greek debt crisis. Thus, the long-term outcome of a monetary union under the theory of OCAs remains a subject of debate.

The European sovereign debt crisis in the wake of theGreat Recession is cited as evidence that theEMU did not fit the criteria for a successful OCA. Critics argue that the EMU did not adequately provide for the greater economic and fiscal integration necessary for cross-border risk-sharing.

Technically, the European Stability and Growth Pact included a “no-bailout” clause that specifically restricted fiscal transfers. However, in practice, this was abandoned early on in the sovereign debt crisis. As Greece’s sovereign debt crisis continued to worsen, there was discussion suggesting that the EMU must account for risk-sharing policies far more extensive than the adopted provisionalbailout system.

Overall, this episode implies that due to the asymmetry of the economic shock to Greece relative to other countries in the EMU and apparent shortfalls in the EMU’s qualification as an OCA under Mundell’s criteria, Greece (and perhaps other countries) might not actually fall within the OCA for the euro.