Trade Competition and Real Exchange Rates

Abstract

The formation of the European Monetary Union (EMU) in 1999 was hailed as a milestone in the history of international monetary affairs. While the traditional theory of optimum currency areas (OCA) focuses on static efficiency gains as the benefit of monetary union, recent studies stress the possibility that currency union boosts trade among member countries and helps synchronize their business cycles, thus obviating the need for national monetary policy (Frankel and Rose 1998). Such dynamic effects of monetary unification should presumably be more substantial when member countries share a similar industrial structure and engage in extensive intra-industry trade (Baldwin 1989; Allen et al. 1998). Moreover, although the general public often attaches a sentimental value to the national legal tender, this psychological barrier to currency union may be more easily overcome if firms in each country have a large number of competitors in other prospective member countries and if people feel that unstable exchange rates can threaten their job security. Other things being equal, therefore, monetary union is more likely to prove successful — both economically and politically — among countries that trade a wide range of similar products with one another.