Eastern Enlargement of the European Monetary Union: An Optimal Currency Area theory view

Abstract

An Optimum Currency Area (OCA) is characterized by a group of countries for which forgoing the exchange rate mechanism, as an instrument of correcting asymmetric shocks, is compensated by other economic policy instruments. In this paper, we address the issue whether the CEEC are a part of a European OCA or not. One of the OCA criteria is the similarity of business cycles among the countries participating in a currency union. The business cycles of the CEEC, as measured by the development of the Gross Domestic Product (GDP) and the Industrial Production (IP) index, are analysed and compared with the cycles of EU member states. Our analysis did not result in clear-cut conclusions concerning membership of a European OCA. In analyzing GDP business cycles we found only some evidence that the three Baltic states (Estonia, Latvia, and Lithuania) could benefit from forming their own currency union. We found little evidence for the preparedness of the candidate countries to join EMU. The analysis of IP data revealed that all of the business cycles in the candidate countries (except in Romania and Lithuania) are related to the German cycle, with some correlation to other EMU members. Most EU member states industry cycles are also correlated with the German cycle. We conclude therefore that a large group of countries, with cycles correlating with Germany, might belong to a European OCA and could therefore benefit from joining EMU. However, Lithuania and Romania clearly do not belong to a European OCA.