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Currency Areas in Theory and Practice*

By Pomfret, Richard
Publication: Economic Record
Date: Wednesday, June 1 2005

HEADNOTE

The dominant theoretical framework for analysing currency domains, optimum currency area (OCA) theory, has a miserable record in explaining actual currency area formation, expansion or dissolution. Ministates use foreign currencies

to avoid high transactions costs; otherwise countries want control over their monetary policy. Nations do not tolerate multiple currencies, because they complicate public revenue and expenditure decisions. These arguments regarding control of monetary policy and content of fiscal policy differ from the OCA theory's emphasis on a trade-off between the microeconomic transactions costs benefits of a wider currency area and the macroeconomic policy benefits of a narrower currency area.

I Introduction

Explaining currency areas is a curious matter. For over 50 years, the theoretical landscape has been dominated by a single paradigm, the optimum currency area (OCA) literature initiated by Mundell (1961) and McKinnon (1963) and continued by Alesinu and Barro (2002). Such dominance might suggest a history of successful empirical testing. Yet, OCA theory is hopeless at explaining the composition of existing currency areas or predicting changes in currency domains.

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Currency Areas in Theory and Practice*

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