DP1473 The Endogeneity of the Optimum Currency Area Criteria

Author(s): Jeffrey A Frankel , Andrew K Rose

Publication Date: September 1996

Keyword(s): Business Cycle , Empirical , Instrumental Variables , Integration , International , Trade

JEL(s): F15 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP1473.asp

A country’s suitability for entry into a currency union depends on a number of economic conditions. These include, inter alia, the intensity or trade with other potential members of the currency union, and the extent to which domestic business cycles are correlated with those of the other countries. But international trade patterns and international business cycle correlations are endogenous. This paper develops and investigates the relationship between the two phenomenon. Using 30 years of data for 20 industrialized countries, we uncover a strong and striking empirical finding: countries with close trade links tend to have more tightly correlated business cycles. It follows that countries are more likely to satisfy the criteria for entry into a currency union after taking steps towards economic integration than before.