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Study Notes

Optimal Currency Areas

AQA, Edexcel, OCR, IB

Last updated 22 Mar 2021

This is an important concept when discussing the single currency

  • An optimal currency area (OCA) is a geographical region where it is thought a single currency would help to maximise welfare and enhance macroeconomic performance
  • An OCA works best when
  • 1.Countries within it are highly integrated with each other i.e. a high percentage of trade in goods and services is done with fellow currency union members
  • 2.Where each economy has a sufficiently flexible labour market to cope with external shocks such as rising oil prices or a major demand-side shock in the world economy. Labour market flexibility might include:
  • i.Flexibility in real wages and salaries at different times during an economic cycle
  • ii.Workers with adaptable skills to reduce structural unemployment
  • iii.A high level of labour mobility within and between members of a currency union
  • iv.Flexible employment contracts including lots of shorter term job contracts
  • 3.An OCA is also likely to work well when the impact of interest rate changes or a change in the exchange rate have a broadly similar effect on businesses and households from country to country.
  • 4.When member nations are willing to make fiscal transfers between each other, for example to help stabilise demand and provide financial support during difficult times

A currency union works best with a small cluster of highly integrated and similar countries, for example Germany, the Netherlands and Austria.

Crucially the countries joining the Euro have not exercised the same budgetary controls – many countries have run up huge fiscal deficits causing a loss of confidence among investors and speculators in international bond markets and have led to a surge in government bond yields in some countries.

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