Mundell Revisited: a Simple Approach to the Costs and Benefits of a Single Currency Area

Abstract

Abstract The paper evaluates the costs and benefits of a single currency area within a unified framework. Conventionally, it is argued that a single currency area carries a welfare loss owing to the sacrifice of exchange rate adjustment in the presence of country‐specific shocks. But in 1973 Mundell argued that a single currency area offers risk‐sharing benefits when capital markets are limited in their ability to facilitate consumption insurance. The authors construct a simple model and compare a system of independent national currencies to a single currency area. The presence of country‐specific shocks may either reduce or enhance the benefits of a single currency area, depending on the importance of exchange rate adjustment relative to risk‐sharing. In a simple quantitative analysis, we find that either regime may dominate, although the utility differences between the two regimes are very small.

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