The Minimum Economic Dividend for Joining a Currency Union
Zorzi, Michele Ca’ ; De Santis, Roberto A. ; Zampolli, Fabrizio
8300 defect for UNSW German Economic Review, 2012, Vol.13(2), pp.127-141 [Peer Reviewed Journal]
how the optimality of a currency union depends on whether it brings an economic dividend in terms of potential growth and the Balassa–Samuelson (BS) effect
Kenen 1969; McKinnon, 1963; Mundell, 1961:
the theory states that the benefits from lower transaction costs and greater price transparency must outweigh the cost of giving up an independent monetary policy and flexible nominal exchange rates
The traditional theory, however, focused mainly on the factors affecting the cost of renouncing to an autonomous stabilisation policy. It did not give prominence to the benefits of a common currency over and above transaction cost savings and greater price transparency, nor on the fact that many of the conditions cited in favour or against the creation of a common currency are not static but endogenous to the policy regime.
Our approach offers the advantage that is conceptually simple and being able to reconcile old and new arguments in favour and against monetary union in a unified framework.
The main contribution of this paper is to show in a unified analytical two-sector, two-country general equilibrium model, how the optimality conditions for forming a currency union depend on both the increase in potential output and BS effect.
The pros include the removal of the distortionary effects on potential output arising from currency risk and output fluctuation. The cons include the emergence of cross-country inflation differentials due to large intersectoral productivity gaps and the reduced macroeconomic stabilisation in an environment of supply and real exchange rate shocks.
The results suggest that both the BS effect and the size of real exchange rate shocks matter to evaluate the optimality of accessing a currency union.
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