Abstract
AbstractA two-country model is developed to show how the optimality of a currency union depends on whether it brings an economic dividend in terms of potential growth and the Balassa-Samuelson (BS) effect (the steady appreciation of the real exchange rate due to cross-country differences in intersectoral productivity gaps). The model shows that such dividend needs to be larger, the higher the BS effect, the smaller the size of the economy, the larger the cross-country difference in the standard deviation of the supply shocks, the smaller their correlation and the larger the standard deviation of real exchange rate shocks. We calibrate the model to quantify such dividend as a function of plausible ranges of the parameter values. The results suggest that both the BS effect and the size of real exchange rate shocks play a key role in evaluating the optimality of accessing the currency union.
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