THE THEORY OF OPTIMUM CURRENCY AREAS, TRADE ADJUSTMENT, AND TRADE

This article seeks to provide a closer integration of the theory of op timum currency areas with the theory of international trade. A currenc y area is treated as a continuous variable ranging from zero to one: z ero if there is no enlargement, and some positive value otherwise, cor responding exactly to the percentage of trade in the enlarged area. Th e benefits of widening a currency area are then regarded, in terms of conventional trade theory, as equivalent to a reduction in transportat ion cost. The costs of widening a currency area are seen, instead, wit h reference to open economy macroeconomics, 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 c urrency area fall, the marginal costs rise, and an optimum size arises . But this size depends heavily on the optimal composition of the memb ers.