Abstract
This paper examines which emerging market regions form optimum currency areas (OCAs) by assessing the symmetry of macroeconomic shocks. We extend the output-prices-VAR framework by adding net exports and the real effective exchange rate as endogenous variables. Based on theoretical considerations, we derive which shocks affect these variables in the long run: shocks to labor productivity, foreign trade, labor supply, and money supply. The considered economies of Central and Eastern Europe, the Commonwealth of Independent States, East and Southeast Asia, and South Asia, exhibit large enough shock symmetry to form a currency union; the economies of Africa, Latin America, and the Middle East do not.
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Notes
Saiki (2005) finds that the benefits from a higher trade volume are asymmetric between developing and developed countries in a currency union. While developed countries typically benefit from higher exports to developing countries in the currency union, developing countries do not necessarily benefit from higher exports.
Dellas and Tavlas (2005) show that countries with relatively rigid wages benefit from joining a common currency area, while countries with relatively flexible wages tend to be worse off.
See Tavlas (2009) for an excellent survey on papers focusing on a possible monetary union in Southern Africa.
An interesting extension of the model would be to include public spending shocks in the specification of the aggregate demand. However, since the model is trimmed to be tested using a VAR model in Section 4 and data on public spending is not available on a quarterly basis for most of the countries considered, we do not include public spending in the theoretical model.
The nominal exchange rate is defined as the amount of domestic currency units to be paid for one foreign currency unit. For simplicity, we normalize foreign prices to one.
The effect of a positive labor productivity shock on output growth is ambiguous (see the four components in brackets in Eq. 17a). Positive effects on output growth result from a higher aggregate supply. An increase in labor productivity yields higher real wages and thereby increases labor supply (first term). Higher labor productivity leads to real appreciation of the domestic currency, which raises the purchasing power of wages, producing greater labor supply (second term). Aggregate supply increases directly due to higher labor productivity (third term). Finally, the negative effect of a positive labor productivity shock is transmitted through aggregate demand (fourth term), as the positive productivity shock leads to real appreciation of the domestic currency and, thus, to falling net exports.
The time series for net exports shows sign changes. To alleviate the problem of outliers, we calculate the growth rate of net exports by dividing the quarterly change in net exports by the absolute value of the mean of net exports during the last eight quarters.
The time series for the Slovakian GDP growth rate and the Brazilian, Chinese, Colombian, Ecuadorian, Hungarian, Iranian, Omani, and Turkish CPI growth rate are detrended to obtain stationary time series. The ADF test does not reject the null of non-stationarity for the Armenian, Czech, Latvian, and Polish CPI growth rates, but the Phillips-Perron test does. To obtain stationary CPI growth rate series for Venezuela and Hong Kong, we calculate the inflation rate of both countries on a year-over-year basis.
We test for structural breaks in the model coefficients using the Quandt-Andrews test but find very few structural breaks which indicates that our estimation results are robust.
To calculate the aggregated shock symmetry measures, we use the (N-1)*N/2 lower triangular elements of the correlation matrix to avoid double counting of symmetrical elements.
We thank two anonymous referees for this helpful suggestion.
The dependent variable of the regression models is the average value of a country’s value-weighted relative shock symmetry measure taken from Table 2.
The coefficient (robust t-value) of fiscal coordination is 0.042 (3.397). The coefficient (robust t-value) of the constant is 0.008 (0.805). The F-statistic is 9.213. The R-squared is 0.146. We have also estimated regression models using the average relative shock symmetry measure instead of the average value-weighted relative shock symmetry measure as the dependent variable, but the results are very similar.
The coefficient (robust t-value) of central bank independence is 0.015 (1.004). The coefficient (robust t-value) of the constant is 0.029 (3.164). The F-statistic is 1.002. The R-squared is 0.018. Taiwan is not included in the regression since data on central bank independence is not available.
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We thank two anonymous referees and the Editor for very helpful comments.
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Eichler, S., Karmann, A. Optimum Currency Areas in Emerging Market Regions: Evidence Based on the Symmetry of Economic Shocks. Open Econ Rev 22, 935–954 (2011). https://doi.org/10.1007/s11079-010-9180-2
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DOI: https://doi.org/10.1007/s11079-010-9180-2