CURRENCY UNIONS AND OPTIMUM:
This Section explains the working of monetary unions and common currency areas. The Section also examines the case for and against optimum currency areas. Countries are facing external economic shocks all the time. By changing its exchange rate, a country can lessen the disruptive effect on its economy. If the country has a flexible exchange rate policy, it can have some potentially harmful effects, like making prices volatile, and governments not being able to check inflation. So a country might like to get the same type of benefits that are conferred by the fixed exchange rate system, and avoid the rigidities at the same time. This is possible
through an optimum currency area. The basic theory of currency unions was put forward by Robert Mundell, who later went on to win a Nobel Prize for his work A country's costs and benefits from joining a fixed-exchange area depend on how well integrated its economy is with its potential partners. The theory of optimum currency areas suggests that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements. A major benefit of fixed rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions as compared
to floating rates. The monetary efficiency gain from joining the fixed exchange rate system is the comparative saving from avoiding the uncertainty and transactions costs that arise from floating exchange rates. A high degree of economic integration between a country and a fixed-exchange rate area amplifies the monetary efficiency gain that accrues to the country when it pegs its exchange rate against the area's currencies. Another reason why high integration with a fixed exchange area increases a country's benefits from joining the area is economic integration leads to international price convergence and hence lessens the scope for independent variation in the pegging country's price level.
Membership in an exchange area may involve costs as well, even when the area has low inflation. These costs arise because a country joining an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilising output and employment. This economic stability loss from joining like its benefits from joining is related to the country's economic integration with its exchange rate partners. Now, a basic result is that a high degree of economic integration between a country and the fixed exchange rate area it joins reduces the resulting economic stability loss due to output market disturbances. This finding as well as the previous one about high degree of economic integration increasing the benefits of a country joining a fixed-exchange rate area explains the existence of optimum currency area which is a region with economies closely linked by trade in goods and services and factor mobility.