Optimal Currency Area: A 20th Century Idea For the 21st Century?

Joshua Aizenman

NBER Working Paper No. 22097
Issued in March 2016
NBER Program(s):   IFM 

This paper takes stock of the history of the European Monetary Union (EMU) and pegged exchange-rate regimes in recent decades, pointing out the need to reshape the optimal currency area (OCA) criteria into the twenty-first century. While contributions from the 1960s regarding the OCA remain relevant, they were written during the Bretton Woods system when financial integration among countries was low and banks were heavily regulated. The post-Bretton Woods greater financial integration and under-regulated financial intermediation have increased the cost of sustaining a currency area and other forms of fixed exchange-rate regimes. A key lesson learned from financial crises is that fast-moving asymmetric financial shocks interacting with real distortions pose a grave threat to the stability of currency areas and fixed exchange-rate regimes. Thus, the odds of a successful currency area depend on the viability of effective institutions and policies that deal with adjustment to asymmetric shocks. The financial crises of recent decades illustrate that the endogeneity of the OCA is time dependent, and that deeper trade and financial integration impacts the stability of the OCA in differential ways. Members of a currency union with closer financial links may accumulate asymmetric balance-sheet exposure over time, becoming more susceptible to sudden-stop crises. In a phase of deepening financial ties, countries may end up with more correlated business cycles. Down the road, debtor countries that rely on financial inflows to fund structural imbalances may be exposed to devastating sudden-stop crises, subsequently reducing the correlation of business cycles between currency area’s members, possibly ceasing the gains from membership in a currency union. A currency union of developing countries anchored to a leading global currency stabilizes inflation at a cost of inhibiting the use of monetary policy to deal with real and financial shocks. Currency unions with low financial depth and low financial integration of its members may be more stable at a cost of inhibiting the growth of sectors depending on bank funding. Similar trade-offs apply to other forms of fixed exchange-rate regimes