Optimum Currency Area (OCA) Theory: Examples in Economics

What Is Optimum Currency Area (OCA) Theory?

Optimum currency area theory (OCA) states that specific areas not bounded by national borders would benefit from a common currency. In other words, geographic regions may be better off using the same currency instead of each country within that geographic region using its own currency.

Understanding Optimum Currency Area (OCA) Theory

Sharing a currency can benefit a geographic region by significantly increasing trade. However, this trade must outweigh the costs of each country giving up a national currency as an instrument to adjust monetary policy. Areas using OCA theory can still maintain a flexible exchange rate system with the rest of the world.

OCA theory was developed in 1961 by Canadian economist Robert Mundell based on earlier work by Abba Lerner. It speculates that there is an optimum geopolitical area that should share a currency, but this geopolitical area doesn’t necessarily correspond with national borders. An optimum currency area could be several nations, parts of several nations, or regions inside a single nation.

According to the theory, a common currency can maximize economic efficiency, provided that the participants meet the following four criteria:

1. A large, available, and integrated labor market that allows workers to move freely throughout the area and smooth out unemployment in any single zone.
2. The flexibility of pricing and wages, along with the mobility of capital, to eliminate regional trade imbalances.
3. A centralized budget or control to redistribute wealth to parts of the area which suffer due to labor and capital mobility. This is a politically difficult one, as wealthy parts of the region may not wish to distribute their surpluses to those that are lacking.
4. The participating regions have similar business cycles and timing for economic data to avoid a shock in any one area.

Princeton professor and international economist Peter Kenen suggested the adding of a fifth criterion of production diversification within the geopolitical area.

Special Considerations

Some economists argue that the United States should be divided into several smaller currency areas, as the country as a whole does not fit the criteria listed in Mundell’s original OCA theory. Economists have calculated that the Southeast and Southwest regions of the United States do not necessarily fit with the rest of the country as an OCA.

Optimum Currency Area Theory Example

Many point to the euro as proof of OCA theory in action. However, some argue that the area did not meet the four criteria as laid out by Mundell’s theory at the time of the euro's creation in 1999. This lack of meeting the requirements, they say, is the reason the eurozone has struggled since its inception. 

Indeed, the OCA theory was put to the test in 2010 as sovereign debt issues faced by many heavily indebted nations in Europe threatened the viability of the European Union (EU), placing severe strains upon the euro. 

According to Global Financial Integrity, a non-profit located in Washington, D.C., peripheral EU countries such as Portugal, Italy, Ireland, Greece, and Spain (PIIGS) experienced slowing growth, lacked international competitiveness, and possessed a labor force that was unproductive.

As these economies slowed, private capital fled, some to stronger eurozone economies, and some to other countries. Also, due to language, culture, and distance difficulties, the labor force in the eurozone is not fluid or mobile. Wages are not uniform across the geopolitical area, either.