The Endogeneity Of The Optimum Currency Area Criteria

A country's suitability for entry into a currency union depends on a number of economic conditions. These include, inter alia, the intensity of trade with other potential members of the currency union, and the extent to which domestic business cycles are correlated with those of the other countries. But international trade patterns and international business cycle correlations are endogenous. This paper develops and investigates the relationship between the two phenomena. Using thirty years of data for twenty industrialized countries, we uncover a strong and striking empirical finding: countries with closer trade links tend to have more tightly correlated business cycles. It follows that countries are more likely to satisfy the criteria for entry into a currency union after taking steps toward economic integration than before.

This paper tests an endogeneity hypothesis of optimum currency area (OCA) criteria (Frankel and Rose, 1998) on a cross-section of OECD countries between 1990 and 1999. The findings indicate that convergence of business cycles relates to intra-industry trade, but has no direct relation between business cycles and bilateral trade intensity. As far as intra-industry trade is positively correlated with trade intensities, this result confirms the OCA endogeneity hypothesis. The endogeneity of OCA linkage criteria implies extensive business cycle harmonization between CEECs and EU countries in the medium term. Published in: Contemporary Economic Policy vol. 22, no 1 (2004) pp. 1-12, ISSN 1074-3529.

It is commonly argued that the successful stabilisation of asymmetric shocks in a monetary union requires, either flexible wages and/or labour mobility, absent inter-regional fiscal transfer payments. The current pattern of relative wage rigidity and labour inertia in Europe is thus viewed by many observers as a problematic factor in the successful functioning of the European common currency area. We investigate in the context of some historical case studies whether monetary integration can bring about a regime shift in the degree of labour market flexibility. Specifically, we employ econometric methods to test whether the onset of monetary union in the US and the Gold Standard in selected countries have rendered real wages more procyclical. Previously entitled: 'The Endogeneity of Optimum Currency Area Criteria in Historical Perspective - Some Lessons for European Monetary Union (EMU)' We find and qualify suggestive evidence from our empirical exercise that indeed a Lucas Critique argument applies so that monetary unions and credibly fixed exchange rate regimes in general might induce wages to carry the burden of macroeconomic adjustment in lieu of independent monetary policy and/or fiscal transfers. We argue that economic theory should borrow a leaf from the book of economic history and - rather than treating wage formation as exogenous - we consider the degree of real wage flexibility to depend upon the nature of the monetary policy regime. We conclude by relating our findings to the European Monetary Union (EMU).

The present paper has two aims. The first aim is to test whether six new member states of the European Union (the six Central and Eastern European Countries) form an optimum currency area (OCA) with the eurozone, in an attempt to assess their readiness for euro adoption. The second aim is to examine whether the introduction of the euro in 1999 and the decision of the countries to seek to join the euro area created any forces fostering their convergence, evidence which would be in line with the theory on the endogeneity of the OCA criteria. Our findings indicate that the introduction of the euro did promote integration of the six new member states and that, at present, they are quite well aligned with the eurozone.

This paper investigates the circumstances under which it is beneficial to participate in a currency area. A two-country monetary model of trade with nominal rigidities encompasses the real and monetary arguments suggested by the optimum currency area literature: correlation of real shocks, international factor mobility, fiscal adjustment, openness, difference in national inflationary biases, correlation of monetary shocks, and benefits of a single currency. The effect of openness on the net benefits is ambiguous, contrary to the usual argument that more open economies are better candidates for a currency area. Countries do not necessarily agree on whether a given currency union should be created.