DP847 The Theory of Optimum Currency Areas, Trade Adjustment and Trade

Author(s): Jacques Melitz
Publication Date: October 1993
Keyword(s): Exchange Rate Regime, International Trade, Optimum Currency Area, Trade Adjustment
JEL(s): F02, F15, F40
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=847

This paper seeks to integrate more closely the theory of optimum currency areas with the theory of international trade. The currency area is considered as a continuous variable ranging from zero to one: zero if there is no enlargement, and some positive value otherwise, corresponding exactly to the percentage of trade in the enlarged area. The benefits of widening a currency area are then treated in the same way as a reduction in transportation costs. The costs of widening a currency area, in turn, are seen as a drop in the speed of adjustment of the terms of trade to their long-run equilibrium level. On this basis it is shown that the marginal benefits of enlarging a currency area fall, the marginal costs rise, and an optimum size arises. This size depends heavily on the optimal composition of the members, however.