Currency Unions

Author:Paolo Mauro

The IMF's mandate to conduct surveillance over international exchange rates has led IMF researchers to consider the desirability of, and the requisite supporting policies for, many currency unions in past decades. Given its broad country membership, the IMF analyzes all currency unions, including unions that consist of small developing countries, a subject often underexplored by researchers in... (see full summary)


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Work related to exchange rate regimes and currency unions is at the core of the IMF's mandate. Member countries of the IMF choose their own exchange rate regimes, but the IMF plays an important advisory role on whether a country's exchange rate regime is consistent with other policies. IMF researchers' interest in currency unions may also have been spurred by Robert Mundell's stint in the IMF Research Department in the early 1960s: his first seminal contributions to the theory of optimum currency areas (OCA) were published about the time he joined the department. 1

IMF researchers have made significant theoretical contributions in this area of study. Bayoumi (1994) developed possibly the first formal OCA model, obtaining some of the key insights (which had been expressed only discursively in earlier papers) on the role of openness, diversification, labor mobility, and correlation of economic shocks in a general equilibrium context with microeconomic foundations. 2 Ricci (1997) not only examined the real aspects of OCA theory, but also its monetary aspects and the interaction with real aspects, and derived the conditions under which openness makes a currency union more attractive. 3

Research has also been conducted on fiscal policies within currency unions and on the institutional features of a common central bank. Debrun (2000) argues that fiscal rules are necessary to provide credibility to a monetary union even with an independent central bank. 4 Bayoumi and Masson (1998) provide evidence that fiscal stabilization policies conducted by individual countries within a currency union tend to be less effective than supranational stabilization policies that provide insurance across countries. 5 Debrun (forthcoming) shows that bargaining among founding member countries of a currency union tends to result in a supranational central bank resembling a national central bank with the strongest inflation-fighting credentials. 6

Empirical work has shown that observed exchange rate and monetary policies can be related to variables identifed as important by OCA theory. Bayoumi and Eichengreen (1998) find that pressures on the exchange rate mainly reflect asymmetric shocks, whereas intervention reflects a country's small size and large trade links-the variables that cause countries to value stable exchange rates according to OCA theory. 7 Ricci and Isard (1998) show that the relative variability (against external currencies) of the euro and a basket of predecessor currencies depends on the relative sizes of countries, their sectoral patterns of trade, and the relative importance of different shocks. 8

Much of the recent work on currency unions at the IMF has focused on whether particular groups of countries have the requisite economic and institutional characteristics for the successful operation of a currency union. As there is no definitive empirical criterion for determining whether a group of countries constitutes an OCA, most empirical analyses compare key OCA variables between existing and proposed unions. Pioneering work in this vein was done by Bayoumi and Eichengreen (1993), who showed that economic disturbances were more correlated among the states of the United States than among the countries of Europe. 9

With a focus on the European Economic and Monetary Union (EMU), Bayoumi and Prasad (1997) examine sectoral data on output and employment for eight U.S. regions and eight European states, and find that labor market adjustment is slower in Europe than in the United States. 10 Bayoumi and Eichengreen (1997) estimate an OCA index for the European countries, and find that Europe Page 6 looked more like an OCA in 1995 than it did in 1987, suggesting that economic integration...

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