What criteria did Mundell use to identify an optimum currency area and how relevant are these criteria today in deciding whether two countries constitute an optimum currency area?

An Optimum Currency Area (OCA) is a geographical region in which maximise economic efficiency is attained by the entire region sharing a single currency (a monetary union), or by several currencies pegging to each other via a fixed exchange rate. National authorities have come to the realisation that by merging with other countries to share a currency, everyone might benefit from gains in economic efficiency. An example of this can be seen in the formation of the euro where the countries involved do not individually match the criteria of an OCA, but believe that together they come close. The aim of national authorities is to establish the correct form of economic integration to maximise efficiency.

One of the original founders of the OCA theory was economist Robert Mundell. In his first paper ‘A Theory of Optimum Currency Areas’ (1961) he presented several principal criteria to create a functioning monetary union. To support these criteria for an OCA I shall on occasion refer to an example of consumer preferences switching from French to German-made products by Paul De Grauwe (2003). The change in consumer preferences will cause an upward shift in aggregate demand in Germany and a downward shift in France as shown in 1 below. The output decline in France and increase in Germany is most likely to cause unemployment to increase in France but decrease in Germany.

The first of the criteria for an OCA is price and wage flexibility throughout the geographical area. This means that the market forces of supply and demand automatically distribute money and goods to where they are needed. For example, with regards to France and Germany under perfect wage flexibility, the unemployed workers in France will reduce their wage claims, and conversely excess demand for labour in Germany will push up the wage rate. This inevitably shifts aggregate supply for France outwards making French products more competitive, and stimulating demand, whereas the opposite occurs for Germany. 2 below shows the effect of wage flexibility as an automatic adjustment mechanism.

Mundell cited the importance of factor mobility as an “essential ingredient of a common currency” (Mundell, 1961) and thus labour mobility across the geographical region is one of Mundell’s main criteria for an OCA. In the case of De Grauwe’s example, French unemployed workers would move to Germany where there is excess demand for labour. This free movement of labour eliminates the need to let wages decline in France and increase in Germany solving both the unemployment problem in France, and the inflationary wage pressures in Germany.

The existence of labour mobility relies on the unrealistic assumptions of free movement of workers between regions regardless of physical barriers such as work permits, cultural barriers such as language difficulties and institutional barriers such as superannuation transferrals. Indeed Peter Kenen referred to the additional costs of retraining workers and there is an “unrealistic assumption of perfect occupational mobility“(Kenen, 1969). Ronald McKinnon observed that “in practice this does not work perfectly as there is no true wage flexibility” (McKinnon, 1979). McKinnon is simply highlighting the point that in reality wage flexibility, as well as perfect labour and capital mobility do not always exist. Considering a case where wages in France do not decline despite the unemployment situation (no wage flexibility), and French workers do not move to Germany (no labour mobility) both Germany and France would be stuck in the original position of disequilibrium. In Germany the excess demand for labour would put pressure on the wage rate, causing an upward shift in the supply curve. The adjustment from the position of disequilibrium would in this case come exclusively from price increases in Germany making French goods more competitive once more. Therefore if wage flexibility and labour mobility does not exist then the adjustment process will be entirely reliant on inflation in Germany.