Unit of account, sovereign debt, and optimal currency area

Abstract

This paper considers how the choice of a unit of account affects the formation of an optimal currency area (OCA). First, we show that forming a currency union internalizes the exchange rate risk and leads to smoothing of consumption levels. However, changing the unit of account of the inherited sovereign debt to a common currency may increase a country’s debt burden if a debtor country is more likely to face a trade deficit within the union. Therefore, the OCA is determined by this trade-off and the debtor country may be better off choosing not to enter the currency union when it faces a high inherited sovereign debt.