Ebook The Endogeneity of the Optimum Currency Area Criteria
Countries considering whether to enter the proposed European Economic and Monetary Union (EMU) weigh the potential benefits of joining the currency union against the inevitable costs. Joining a currency union brings benefits such as a reduction in the transactions costs associated with trading goods and services between countries with different moneys.
Countries with close international trade links would potentially benefit greatly from a common currency and are more likely to be members of an optimum currency area (OCA). Thus, the nature and extent of international trade is one criterion for EMU entry, or, more generally, membership in an OCA.
On the other hand, joining EMU brings costs. Cited most frequently is foregoing the possibility of dampening business cycle fluctuations through independent counter-cyclic monetary policy. Countries with idiosyncratic business cycles give up a potentially important stabilizing tool if they join a currency union. Another criterion for EMU entry is therefore the cross-country correlation of business cycles. Countries with "symmetric" cycles are more likely to be members of an OCA. Succinctly, countries with tight international trade ties and positively correlated business cycles are more likely to join, and gain from EMU, ceteris paribus.
These topics have already been closely studied by economists. Estimates of the transactions costs that might be saved by EMU have been summarized by the Commission of the European Communities (1990). A number of economists, including Bayoumi and Eichengreen (1993a, 1993b, 1994, 1996), have analyzed the business cycles and shocks affecting different potential EMU members, so as to be able to quantify the potential importance of national monetary policy. Our aim in this paper is to link the two issues so as to make a simple point. We argue that a naïve examination of historical data gives a misleading picture of a country's suitability for entry into a currency union, since both criteria are endogenous .
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