Essays in Honor of Mordechai Kreinin
Edited by Michael G. Plummer
Chapter 4: Why Does Optimal Currency Area Theory Fail to Predict Changes in Currency Areas? Evidence from Europe and Lessons for Asia
4. Why does optimal currency area theory fail to predict changes in currency areas? Evidence from Europe and lessons for Asia Richard Pomfret The dominant theoretical framework for analysing currency domains has been the optimum currency area theory originating from Mundell (1961) and McKinnon (1963). Much of the applied literature on currency area formation has come from Europe, following steps towards monetary integration within the European Union (EU) since 1970. The appearance of euro banknotes in January 2002 was a highly visible sign of monetary union among EU members, and many commentators have drawn positive lessons from European monetary union for monetary integration in other parts of the world. Yet the process of currency union in Europe has not fitted in with the predictions of optimal currency area (OCA) theory. One of the few empirical studies using OCA theory to identify the most likely candidates for currency union (Kreinin and Heller, 1974, p. 137) concluded that among the OECD countries Italy, Sweden and Switzerland should be keenest to abandon their national currencies. From the post-euro perspective, a score of one out of three raises questions about the success of OCA theory in explaining changes in actual currency areas. This chapter argues that the European experience of the 1990s is richer than a simple story of the inevitability of monetary integration. In Eastern Europe the number of currencies proliferated between 1991 and 1993 with the dissolution of the Yugoslav, Czechoslovak and Soviet currency areas, so that Europe had more independent currencies...
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