Abstract
This article provides a microeconomic foundation for Mundell’s optimum currency area theory. We consider twin countries where labor forces are fixed to each country although the real capital moves internationally. When the central bank in each country behaves non-cooperatively, it will raise the domestic interest rate to attract more real capital and increase the rent of her residences. However, the fierce competition between the central banks ultimately exacerbates the disparity in income distribution. Moreover, when the real capital or the financial intermediary as its agent does not have a nationality, the worsened income distribution also results in the inefficient resource allocation. Thus, such twin countries should unify their central banks and coordinate their monetary and interest policies. In other words, these countries constitute an optimum currency area.
Highlights
Income disparity is not limited to developing countries
This article considers why such an undesirable economic consequence is invoked when constructing a microeconomic foundation for the optimum currency area theory originating from Mundell’s [1] seminal work
Since the outcomes of the first stage are summarized by (10), taking the social welfare (8) and the equilibrium condition for each aggregated goods market (9) into consideration, the best response of each central bank is to maintain the full-employment equilibrium, which is defined as the amount of real capital that is associated with its country
Summary
Income disparity is not limited to developing countries. Advanced economies face this growing problem. When small twin countries with identical economic structure are in this situation, their central banks compete to invite more real capitals to enrich their economy as long as the countries attain full employment. Such competition has the following devastating conesquence. Each country is supplied with an amount of real capital, and the income disparity and inefficient resource allocation within the nations are entirely resolved. The small twin countries constitute an optimum currency area whenever the real capital mobility is complete.
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