4 Optimal Currency Areas: New Aspects of the Literature
(a) Harmonisation of Business Cycles
One of the supposed major advantages of maintaining a separate currency is the ability to smooth business cycle fluctuations through independent and counter-cyclical monetary policy. For this reason it is often argued that a necessary criteria for entering into a monetary union is that there is a high degree of correlation of business cycles between the partner countries. This question is obviously empirical, and there have been several estimates of the degree to which business cycles in different countries are correlated. As Frankel and Rose (1998) point out, however, these exercises are potentially rather uninformative as the extent to which business cycles across regions are correlated will depend on the extent to which they trade, and the extent to which they have synchronised monetary policy. Again this is an empirical question, but if monetary union leads to greater trade, and greater trade leads to a greater correlation of business activity, entering a monetary union will enhance the harmonisation of the two regions’ business cycles.
Frankel and Rose estimate the degree to which business cycle harmonisation depends on trade using cross-country data between 1959 and 1993. They find a clear positive relationship: countries that trade more have more highly correlated business cycles. From this they make the following observations:
“Some countries may appear, on the basis of historical data, to be poor candidates for EMU entry. But EMU entry per se, for whatever reason, may provide a substantial impetus for trade expansion; this in turn may result in more highly correlated business cycles. That is, a country is more likely to satisfy the criteria for entry into a currency union ex post than ex ante.” (Frankel and Rose, 1998, p1024)
In short, a country forming a monetary union with another country will have a reduced need for a separate monetary policy. It should be stressed that this argument is presented in the context of countries using monetary policy to offset real economic shocks. The principle has wider ramifications, however, because if monetary policy is a cause of economic shocks, forming a monetary union will eliminate this cause of asynchronous cyclical fluctuations.
