A Model of An Optimum Currency Area


A Model of an Optimum Currency Area
by Luca A. Ricci

This paper develops a two-country model to investigate the circumstances under
which it is beneficial to participate in a currency area. It captures both the
real and monetary arguments suggested by the optimum currency area literature
in a simple monetary model of trade with nominal rigidities. The net benefits
that one country expects from participation in a currency union increase with
the correlation of real shocks between countries; the degree of international
labor mobility; the degree of adjustment provided by a fiscal tool; the
difference between the inflationary bias of the domestic authority and the
inflationary bias of the authority of the currency union; the variability of
domestic monetary shocks; and the extent of the deadweight and efficiency gains
deriving from the adoption of a single currency. The same net benefits decrease
with the variability of real shocks; the variability of foreign monetary
shocks; and the correlation of monetary shocks between countries.

The main result of the study is that the effect of the degree of openness on
the net benefits is ambiguous, in contrast with the usual argument that the
more open economies are, the better candidates they make for a currency area.
It is also interesting to note that countries do not necessarily agree on the
desirability of creating a given currency union.