The academic debate concerning cross-country currency arrangements started in earnest with Milton Friedman (1953), who argued for a worldwide flexible exchange rate system. He was joined by Robert Mundell (1963), who made an elegant case for a worldwide mixture of fixed and flexible rates. Since Friedman and Mundell, the debate has continued to rage, with those advocating cross-country currency arrangements arguing that their success depends on considerations ranging from countries’ production structures to the credibility of their monetary authorities. The complexity of the arguments has far outstripped the ability of policymakers to apply the principles developed in the arguments. Indeed, the countries for which these arguments may be relevant are often among the less sophisticated in terms of market development and data collection.
This paper provides an explicit model of Mundell’s optimum currency area argument, which indicates that Mundell somewhat understated the case for fixed exchange rates between two areas of labor mobility. Whereas Mundell assumed that the relevant macroeconomic shocks were demand-side shocks, the model in the paper includes supply-side shocks. The paper concludes that such shocks can give rise to strong efficiency gains for a fixed-rate system when labor is mobile and prices are sticky.