Seminar Papers, Institute for International Economic Studies, Stockholm University
No 611:
Economic Structure and the Decision to Adopt a Common Currency
Jeffrey A. Frankel and Andrew K. Rose ()
Abstract: Everyone studying EMU cites the theory of Optimum Currency
Areas: whether a country like Sweden should join the currency union depends
on such parameters as the extent of Swedish trade with other EU members and
the correlation of Sweden’s income with that of other members. Few
economists have focused on what we consider one of the most interesting
aspects of this issue. Trade patterns and income correlations are
endogenous. Sweden could fail the OCA criterion for membership today, and
yet, if it goes ahead and joins anyway, could, as the result of joining,
pass the Optimum Currency Area (OCA) criterion in the future. (Further,
even if Sweden does not enter EMU quickly, it will be more likely to
satisfy the OCA criteria in the future as a result of its recent accession
to the EU.)
The few economists who have identified the importance of
the endogeneity of trade patterns and income correlation are divided on the
nature of the relationship between the two. This is an important empirical
question, which may hold the key to the answer regarding whether it is in
Sweden’s interest to join EMU.
We review the OCA theory, highlighting
the role of trade links and income links. Then we discuss and analyze the
endogeneity of these parameters. We present econometric evidence suggesting
strongly that if trade links between Sweden and the rest of Europe
strengthen in the future, then Sweden’s income will become more highly
correlated with European income in the future (not less correlated, as some
have claimed). This has important implications for the OCA criterion. It
means that a naïve examination of historical data gives a biased picture of
the effects of EMU entry on Sweden. It also means that EMU membership is
more likely to make sense for Sweden in the future than it does today.
Keywords: EMU; Optimum Currency Area; trade patterns; income correlations; (follow links to similar papers)
JEL-Codes: F15; F33; (follow links to similar papers)
53 pages, November 5, 1997
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