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In 1961, economist Robert Mundell introduced a theory which stated that a common currency in certain monetary unions, or “Optimum Currency Areas” as he called them, could maximize economic efficiency. He developed several criteria that were required for a region to qualify as an optimum currency area, such as a high level of labor and capital mobility, flexible labor markets and wages, openness of economies and decentralized monetary and fiscal policy. Mundell saw flexible labor and capital factors as an essential ingredient for a currency union to properly function in a fixed exchange rate mechanism. The higher the factor mobility, the more effective a centralized monetary and fiscal policy would be, he posited. In the absence of floating currencies, high factor contribution to economic growth was, in Mundell’s view, the only effective adjustment mechanism during demand or supply shocks.
Ronald McKinnon advanced Mundell’s work in 1963 by empirically looking at the openness of trade across economies. McKinnon’s work became a cornerstone of the optimum currency area theory: postulating that the more open economies are in trade with one another, the less asynchronous output fluctuations will be between countries resulting from demand or supply shocks. Like Mundell, McKinnon concluded that the higher the factor mobility, the more synchronized business cycles would become, which is a key ingredient in optimum currency areas. ________________________________________
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