Theory of Optimum Currency Areas

Abstract

To clarify the economic rationale of a currency union we have to judge it from the point of view of markets and against the background of the market agents’ experiences with other currency systems. In case of national currencies which are bound together in a system of fixed exchange rates, governments face the risk of balance of payments imbalances which may finally lead them to exchange rate adjustments. With flexible exchange rates, on the other hand, markets experienced large fluctuations in currency prices, not only in the form of short-term volatility, which can be hedged. More important were the long-term variations of exchange rates which could have lasting effects on the real terms of trade. These developments were barely predictable since they resulted largely from the instability of expectations in financial markets.