1 Introduction

After the dearth of publications following Mundell's (1961) path-breaking article on optimal
currency areas recent years have seen a pronounced rise in interest in this topic. This is due to
the fact
that as the number of countries increases and their economies become ever more
integrated, questions arise once again on whether there are economic bene_ts from establishing currency
unions,
and if so, which countries should form such unions. For instance, the surge in international
trade
in goods and assets should raise the transaction bene_ts from a common currency, and
unions are
a more credible instrument for ination control than simply _xing exchange rates.
Indeed, many countries around the world have decided to set up monetary unions, most
notably
twelve of the European Union's 15 member states. Similar arrangements are under
consideration
in Africa and the Middle East, and dollarization (forming a currency union with America) has
been implemented by several smaller Latin America nations (see Alesina et al. (2002)).
Following the discussion in De Grauwe (2000, 2003) this survey reects on the arguments
provided in favor of and against the creation of a monetary union, similar in style to a \costbene_t analysis", and presents related empirical evidence.

2 The Costs

The costs of a monetary union stem primarily from the loss of an independent monetary
policy,
i. e. the ability to control the ow of money in the economy by setting interest rates and
exchange
rates. The national central bank will either be abolished or devoid of any real power, and
monetary
policy will be conducted on a union-wide level.
The ability to inuence exchange rates may be important for adjusting economy activity if
certain di_erences between countries exist, as well as in other circumstances. While other
policy
instruments often exist, they are likely to be more painful, thereby constituting the \cost
side" of
a monetary union. This chapter rests on the theory of \Optimal Currency Areas" 1 (OCA
theory)
introduced by Robert Mundell2 in 1961, and further developed by McKinnon (1963), Kenen
(1969)
and Alesina and Barro (2002).

2.1 Shifts in demand

Suppose that two countries, say France and Germany, form a monetary union, with a
common
currency (the euro) and a common central bank. Suppose further that the preferences of
consumers in both countries shift from French-made to German-made products, which is
referred to
as an asymmetrical demand shock. According to standard aggregate demand/aggregate
supply
models, higher demand for German products will lead to higher output and lower
unemployment
in Germany, and lower output and higher unemployment in France. Both countries now
experience
adjustment problems; France struggles with higher unemployment and Germany with
inationary
pressures due to its economic boom. There are two mechanisms which would be able to
automatically restore equilibrium:
_ Wage exibility: In the case of exible wages, unemployed workers in France will o_er
their labor services at lower wages, while there will be upward pressure on wages in Ger-

many due to excess demand for labor. This allows price reduction and output expansion
in France, and implies the opposite for Germany. These mechanisms restore equilibrium by
making French products more attractive, thus increasing demand for them. Second-order
e_ects reinforce this tendency: The wage and thus price increases in Germany render French
products even more competitive, further raising aggregate demand for French products (vice
versa for Germany.)
_ Labor mobility: If labor is mobile enough, then unemployed workers in France would
relocate to Germany, with its excess demand for labor. Wages would not need to rise in
Germany or fall in France, and there is not going to be any inationary pressure in Germany
or additional unemployment in France.
1Originally
2For

called the theory of \Optimum Currency Areas".

his work on the economics of exchange rate regimes Mundell was awarded the Nobel prize for Economic