Scandinavian Working Papers in Economics

Seminar Papers,
Stockholm University, Institute for International Economic Studies

No 611: Economic Structure and the Decision to Adopt a Common Currency

Jeffrey A. Frankel and Andrew K. Rose ()
Additional contact information
Jeffrey A. Frankel: Economics Department, University of California, Postal: University of California, Berkeley, CA 94720-3880, USA
Andrew K. Rose: Economics Department, University of California, Postal: University of California, Berkeley, CA 94720-1900, USA

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

JEL-codes: F15; F33

53 pages, November 5, 1997

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