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

Abstract

This paper develops an analytical model to evaluate the costs and benefits of a single currency area within a unified framework, inspired by the separate arguments of Mundell (1961) and (1973). The more familiar argument is that, in the presence of country-specific shocks, a single currency area imposes a welfare cost associated with the lack of exchange rate adjustment. But Mundell (1973) argues that a single currency area offers risk-sharing benefits in the face of country-specific shocks and restricted ability for capital markets to facilitate consumption insurance. In our model, a single currency area, as compared with a system of national currencies and floating exchange rates, brings both welfare costs associated with the absence of exchange rate adjustment and welfare benefits associated with risksharing. The model provides a utility-based comparison of costs versus benefits. While theoretically, either monetary regime may dominate, quantitatively, the net welfare benefits of a single currency area are likely to be negative.

JEL Classification: F33, F41