Convergence Towards an Optimal Currency Area in the European Union

This essay uses the European Union as a case study to analyze the conditions for an optimal currency area, the regional differences that give rise to divergences from optimal conditions, and how to measure divergence. The essay reviews the extensive body of theoretical literature on optimal currency areas (OCA), analyzes the historical evidence and documents that outline the economic institutions of the EU, and performs an empirical factor analysis on different possible indicators of convergence to identify to the most important variables. In the absence of adjustment mechanisms, economic geography plays an essential role in forming an OCA because members of a currency area must have similar monetary policy needs. The most important indicators of convergence towards an optimal currency area include measures of real effective exchange rates, labor productivity, inflation, and patterns of production