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Optimum currency area theory

Optimum currency area theory adopts the presumption that a currency area confers a benefit upon its members by eliminating exchange rate risks and reducing transactions costs. Its analysis concerns the extent to which that benefit may be offset by the risk of an additional cost when there is a recession. Such an additional cost arises when there is a difference between the monetary policy response to the recession that is appropriate for a member country, and that which is appropriate for the currency area as a whole. When that happens, some member countries may suffer unemployment and other economic costs that they could have avoided if they had retained control over their national monetary policies. It is liable to happen when the currency area experiences an asymmetric shock which affects the economies of some member countries more than others.

The term "optimum currency area" is believed to have been coined by the eminent economist Robert Mundell to denote the theoretical concept of an area in which there are no such offsetting costs. Mundel's analysis demonstrated that a sufficient condition for its definition would be would be either a frictionless migration of labour, or a frictionless adaptation of labour costs, in response to a change in demand.

Application of the theory to the Eurozone

The eurozone does not meet Mundell's labour migration or cost flexibility requirements. Labour mobility is low and there is limited wage flexibility.