Theory of optimal currency zones

The prerequisites for the development of the theory arose a couple of decades before its formalization. In the late 1940s and early 1950s, several leading American economists, such as Abba Lerner , Milton Friedman , James Mead , Tibor de Skitowski , laid the foundations for analysis in international macroeconomics ^[2] . They studied the interregional problems of the national economy. In particular, the role of the central (federal) monetary and fiscal authorities, as well as the interregional movement of goods and factors of production in the course of the regions achieving macroeconomic equilibrium.

The creator of the theory is Robert Mundell, an American economist of Canadian origin. In 1961, he reformulated the analysis of regional achievement of macroeconomic equilibrium. Mandell proceeded from the fact that the mobility of production factors may be incomplete and, as a result, the restoration of equilibrium in a group of regions will not be effective. He proposed to solve the inverse problem: to determine the group of regions (their geographical boundaries) in such a way as to ensure internal and external balance. It will be advantageous for this group of regions or countries to have a single currency, whose rate can float against the currencies of other groups or countries, or to fix exchange rates in relation to each other ^[1] .

In addition to Mandell, Ronald McKinnon from Stanford University and Peter Kenen from Princeton University participated in the development of the theory. They expanded the criteria by which the optimal zone is determined.

The work of economists Mandell, McKinnon and Kenen laid the foundation for the theory of optimal currency zones. In the classic version, the currency zone meets several requirements ^[3] :

• labor mobility and / or wage and price flexibility;
• exposure to asymmetric shocks;
• foreign trade openness and (or) trade integration;
• sufficient size of the economy;
• similarity of economic structures of regions;
• product diversification of exports;
• fiscal integration.

The early theory of optimal currency zones was seen as a hybrid of Keynesian and monetarist approaches to international macroeconomics .

The classical version of the theory had several drawbacks ^[4] . Firstly, a small open economy can be characterized by low labor mobility, which implies the choice of a floating exchange rate rather than a fixed one. Secondly, small open economies, on average, are poorly diversified. For them, a floating exchange rate is preferable. Thirdly, the more diversified the economy, the less it is exposed to external shocks and the weaker its incentives for currency integration.

In earlier works, currency zones were considered as static models. Attention was paid to the criteria that the economy must satisfy in order to introduce a fixed rate or a single currency. Dynamic analysis gave the theory a new impetus for development. There is a correlation between the criteria of optimality. In particular, the growth of foreign trade openness of the economy leads to an increase in the sensitivity of prices to the exchange rate. High mobility of factors of production, including capital mobility, can compensate for the lack of price flexibility. Fiscal federalism allows in the short term to compensate for shocks due to the redistribution of resources. Thus, there is interchangeability between optimality criteria.

Professors Jeffrey Frenkel and the University of California, Andrew Rose, have formulated a new endogenous version of the theory. They investigated the relationship between two optimality criteria: trade integration and asymmetric shocks ^[5] . They conclude that the reduction of foreign trade barriers leads to the deepening of product or sectoral specialization of the regions. On the other hand, increased trade integration leads to synchronization of business cycles . Thus, joining a currency zone brings certain benefits, in particular, reduces exposure to shocks and increases the degree of optimality of the zone. However, as more and more conformity to optimal characteristics, the benefits of currency integration are reduced.

In macroeconomic literature, the theory of optimal currency zones is the most popular tool for analyzing currency integration. Alternative concepts that could replace the theory of optimal currency zones are absent or are at the initial stage of development. An example of an alternative is the simpler gravitational model . In the theory of optimal currency zones, developed tools of applied analysis are used. In particular, classical correlation and regression analysis, index analysis, structural vector autoregression and others. Due to the fact that the theory describes various aspects of integration, it goes beyond the topic of currency integration. The theory of optimal currency zones serves to assess the feasibility of international (political) integration of countries with common interests.

• Monetary Union
• Macroeconomics
• International economics
• Model IS-LM-BP
• Floating exchange rate
• Fixed exchange rate

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• Moiseev S. Adventures of the theory of optimal currency zones // Issues of Economics, 2016. - No. 2. - p. 56-76.
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