Rethinking Optimum Currency Area Theory: Endogenous Synchronisation of Shocks in Europe

Abstract

This work aims to assess whether the hypothesis of endogenous synchronisation of shocks is verified in the European Economic and Monetary Union (EMU). A state-space model, which yields time-varying coefficients, is estimated with structural demand and supply shocks to several European economies and those of Germany. The goals is to obtain dynamic measures of correlation, which can help understand to what extent have structural shocks to European economies become more or less synchronised with Germany's throughout the EMU experience. Evidence shows that demand shocks have become increasingly synchronised, which corroborates the hypothesis of endogeneity. However, this phenomenon does not seem to be restricted only to EMU members. Furthermore, results prove that this increasing synchronisation occurred mainly in peripheral countries. For supply shocks conclusions are not as clear. Nevertheless, results do seem to point to the fact the countries outside the EMU have not become more structurally similar to Germany.