On the Necessity of Optimum Currency Areas: The Case for Perfect Capital Mobility and Immobile Labor Forces

Abstract

This chapter provides a microeconomic foundation for Mundell ’s optimum currency area theory. The model considers twin countries where labor forces are fixed to each country even though real capital moves internationally. When the central bank in each country behaves non-cooperatively, it will raise the domestic interest rate to attract more real capital and increase the rent of residences. However, fierce competition between central banks ultimately exacerbates disparities in income distribution. Moreover, when real capital does not have a nationality, a worsened income distribution also results in inefficient resource allocation. Thus, twinned countries should unify their central banks and coordinate their monetary and interest policies. In other words, these countries constitute an optimum currency area.