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This PDF is a selection from a published volume
from the National Bureau of Economic Research
Volume Title: NBER Macroeconomics Annual 2002,
Volume 17
Volume Author/Editor: Mark Gertler and Kenneth
Rogoff, editors
Volume Publisher: MIT Press
Volume ISBN: 0-262-07246-
Volume URL: http://www.nber.org/books/gert03-
Conference Date: April 5-6, 2002
Publication Date: January 2003
Title: Optimal Currency Areas
Author: Alberto Alesina, Robert J. Barro, Silvana
Tenreyro
URL: http://www.nber.org/chapters/c
Alberto (^) Alesina, RobertJ. Barro,
and Silvana Tenreyro
HARVARDUNIVERSITY,NBER,AND CPER;HARVARD
UNIVERSITY,HOOVERINSTITUTION,AND NBER;AND FEDERAL
RESERVEBANK OF BOSTON
Optimal Currency
Areas
1. Introduction
Is a country by
definition an optimal currency
area? If the optimal
number
of currencies is less than the number of existing countries, which countries
should form currency
areas?
This question, analyzed
in the pioneering
work of Mundell (1961) and
extended in Alesina and Barro (2002), has jumped
to the center stage
of
the current policy debate, for several reasons. First, the large
increase in
the number of independent
countries in the world led, until recently,
to
a roughly
one-for-one increase in the number of currencies. This prolifera-
tion of currencies occurred despite
the growing integration
of the world
economy.
On its own, the growth
of international trade in goods
and
assets should have raised the transactions benefits from common curren-
cies and led, thereby, to a decline in the number of independent moneys.
Second, the memory
of the inflationary
decades of the seventies and eight-
ies encouraged
inflation control, thereby generating consideration of ir-
revocably
fixed exchange
rates as a possible
instrument to achieve price
stability. Adopting
another country's currency
or maintaining
a currency
board were seen as more credible commitment devices than a simple
fix-
ing
of the exchange
rate. Third, recent episodes
of financial turbulence
have promoted
discussions about "new financial architectures." Although
this dialogue
is often vague
and inconclusive, one of its interesting
facets
We are grateful
to Rudi Dombusch, Mark Gertler, Kenneth Rogoff, Andy Rose, Jeffrey
Wurgler,
and several conference participants
for very
useful comments. Gustavo Suarez
provided
excellent research assistance. We thank the NSF for financial support through
a
grant
with the National Bureau of Economic Research.
Optimal Currency
Areas ?
303
The purpose
of this paper
is to evaluate whether natural currency
areas
emerge
from an empirical investigation.
As a theoretical background,
we
use the framework developed by
Alesina and Barro (2002), which dis-
cusses the trade-off between the costs and benefits of currency
unions.
Based on historical patterns
of international trade and of comovements
of prices
and outputs,
we find that there seem to exist reasonably
well-
defined dollar and euro areas but no clear yen
area. However, a country's
decision to join
a monetary
area should consider not just
the situation
that applies
ex ante, that is, under monetary autonomy,
but also the condi-
tions that would apply
ex post,
that is, allowing for the economic effects
of currency
union. The effects on international trade have been discussed
in a lively
recent literature prompted by
the findings
of Rose (2000). We
review this literature and provide
new results. We also find that currency
unions tend to increase the comovement of prices
but are not systemati-
cally
related to the comovement of outputs.
We should emphasize
that we do not address other issues that are im-
portant
for currency adoption,
such as those related to financial markets,
financial flows, and borrower-lender relationships.
We proceed
this way
not because we think that these questions
are unimportant,
but rather
because the focus of the present inquiry
is on different issues.
The paper
is organized
as follows. Section 2 discusses the broad evolu-
tion of country sizes, numbers of currencies, and currency
areas in the
post-World
War II period.
Section 3 reviews the implications
of the theo-
retical model of Alesina and Barro (2002), which we use as a guide
for
our empirical investigation.
Section 4 presents
our data set. Section 5 uses
the historical patterns
in international trade flows, inflation rates, and the
comovements of prices
and outputs
to attempt
to identify optimal
cur-
rency
areas. Section 6 considers how the formation of a currency
union
would change
bilateral trade flows and the comovements of prices
and
outputs.
The last section concludes.
- Countriesand Currencies
In 1947 there were 76 independent
countries in the world, whereas today
there are 193. Many
of today's
countries are small: in 1995, 87 coun-
tries had a population
less than 5 million. Figure 1, which is taken from
Alesina, Spolaore,
and Wacziarg (2000), depicts
the numbers of countries
created and eliminated in the last 150 years.
In the period
between World
Wars I and II, international trade collapsed,
and international borders
- For a recent theoretical discussion of these issues, see Gale and Vives (2002).
- The initial negative
bar in 1870 represents
the unification of Germany.
304? ALESINA, BARRO, & TENREYRO
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1876
1879
1882
1885
1888
1891
1894
1897
1900
1903
1906
1909
1912
1915
1918
1921
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1927
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1936
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OptimalCurrency
Areas*^307
However, sometimes forms of nationalistic pride have led countries into
disastrous courses of action. Therefore, the argument
that a national cur-
rency
satisfies nationalistic pride
does not make an independent money
economically
or politically
desirable. In fact, why a nation would take
pride
in a currency escapes us; it is probably
much more relevant to be
proud
of an Olympic
team. As for national identity, language
and culture
seem much more important
than a currency, yet many
countries have will-
ingly
retained the language
of their former colonizers. Moreover, many
countries undergoing
extreme inflation, such as in South America, tended
to change
the names of their moneys (^) frequently,
so even a sentimental
attachment to the name "peso"
or "dollar" seems not to be so important.
In any event, as already mentioned,
one can detect a recent tendency
toward formation of multicountry monetary
areas. In the next decade, the
ratio of currencies to independent
countries may
decrease substantially,
beginning
with the adoption
of the euro in 2002.
- TheCostsand Benefitsof Currency
Unions
We view this analysis
from the perspective
of a potential client country
that
is considering
the adoption
of another country's money
as a nominal anchor.
3.1 TRADEBENEFITS
Country
borders matter for trade flows: two regions
of the same country
trade much more with each other than they
would if an international
border were to separate
them. McCallum (1995) looked at U.S.-Canadian
trade in 1988 and suggested
that this effect was extremely large:
trade
between Canadian provinces
was estimated to be a staggering
larger
than that between otherwise comparable provinces
and states.
More recent work by
Anderson and van Wincoop (2001) argues
that this
effect from the U.S.-Canada border was vastly exaggerated
but is still
substantial: the presence
of an international border is estimated to reduce
trade among
industrialized countries by 30%, and between
the United
States and Canada by
44%. The question
is why
national borders matter
so much for trade even when there are no explicit
trade restrictions in
place. Among
other things, country
borders tend to be associated with
different currencies. Therefore, given that border effects are so large,
the
elimination of one source of border costs-the change
of currencies-
might
have a large effect on trade.
Alesina and Barro (2002) investigate the relationship
between currency
- Obstfeld and Rogoff (2000) argue
that these border effects on trade may
have profound
effects on a host of financial markets and may explain
a lot of anomalies in international
financial transactions.
OptimalCurrency
Areas ?
anchor plus
the change (positive
or negative)
in its price
level relative to
that of the anchor. In other words, if the inflation rate in the United States
is 2%, then in Panama it will be 2% plus
the change
in relative prices
between Panama and the United States. Therefore, even if the anchor
maintains domestic price stability, linkage
to the anchor does not guaran-
tee full price stability
for a client country.
The most likely
anchors are large
relative to the clients. In theory,
a
small but very
committed country
could be a perfectly good
anchor. How-
ever, ex post,
a small anchor may
be subject
to political pressure
from the
large
client to abandon the committed policy.
From an ex ante perspec-
tive, this consideration disqualifies the small country
as a credible anchor.
In summary:
The countries that stand to gain
the most from giving up
their currencies are those that have a history
of high
and volatile inflation.
This kind of history
is a symptom
of a lack of internal discipline
for mone-
tary policy. Hence, to the extent that this lack of discipline
tends to persist,
such countries would benefit the most from the introduction of external
discipline. Linkage
to another currency
is also more attractive if, under
the linked system,
relative price
levels between the countries would be
relatively
stable.
3.3 STABILIZATIONPOLICIES
The abandonment of a separate currency implies
the loss of an indepen-
dent monetary policy.
To the extent that monetary policy
would have
contributed to business-cycle stabilization, the loss of monetary indepen-
dence implies
costs in the form of wider cyclical
fluctuations of output.
The costs of giving up monetary independence
are lower the higher
the association of shocks between the client and the anchor. The more the
shocks are related, the more the policy
selected by
the anchor will be
appropriate
for the client as well. What turns out to matter is not the
correlation of shocks per se, but rather the variance of the client country's
output expressed
as a ratio to the anchor country's output.
This variance
depends partly
on the correlation of output (and, hence, of underlying
shocks) and partly
on the individual variances of outputs.
For example,
a small country's output may
be highly
correlated with that in the United
States. But, if the small country's
variance of output
is much greater
than
that of the United States, then the U.S. monetary policy
will still be inap-
propriate
for the client. In particular,
the magnitude
of countercyclical
monetary policy
chosen by
the United States will be too small from the
client's perspective.
The costs implied by
the loss of an independent money depend also
on the explicit
or implicit
contract that can be arranged
between the an-
chor and its clients. We can think of two cases. In one, the anchor does
310 *^ ALESINA,BARRO,& TENREYRO
not change
its monetary policy regardless
of the composition
and experi-
ence of its clients. Thus, clients that have more shocks in common with
the anchor stand to lose less from abandoning
their independent policy
but have no influence on the monetary policy
chosen by
the anchor coun-
try.
In the other case, the clients can compensate
the anchor to motivate
the selection of a policy
that takes into account the clients' interests, which
will reflect the shocks that they experience.
The ability
to enter into such
contracts makes currency
unions more attractive. However, even when
these agreements
are feasible, the greater
the association of shocks be-
tween clients and anchor, the easier it is to form a currency
union. Spe-
cifically,
it is cheaper
for a client to buy
accommodation from an anchor
that faces shocks that are similar to those faced by
the clients.9 The alloca-
tion of seignorage arising
from the client's use of the anchor's currency
can be made part
of the compensation
schemes.
The European Monetary
Union is similar to this arrangement
with com-
pensation,
because the monetary policy
of the union is not targeted
to a
specific country (say Germany),
but rather to a weighted average
of each
country's shocks, that is, to aggregate
euro-area shocks. In the discussion
leading up
to the formation of the European Monetary Union, concerns
about the degree
of association among
business cycles
across potential
members were critical. In practice,
the institutional arrangements
within
the European
Union are much more complex
than a compensation
scheme, but the point
is that the ECB does not target
the shocks of any
particular country,
but rather the average European
shocks.
In the case of developing countries, the costs of abandoning
an indepen-
dent monetary policy may
not be that high,
because stabilization policies
are typically
not well used when exchange
rates are flexible. Recent work
by
Calvo and Reinhart (2002) and Hausmann, Panizza, and Stein (1999)
suggests
that developing
countries tend to follow procyclical monetary
policies; specifically, they
tend to raise interest rates in times of distress
to defend the value of their currency.
To the extent that monetary policy
is not properly
used as a stabilization device, the loss of monetary
in-
dependence
is not a substantial cost (and may actually be a benefit) for
- Note that, in theory,
a small country
could be an ideal anchor because it is cheaper
to
compensate
such an anchor for the provision
of monetary
services that are tailored to
the interests of clients. However, as discussed before, a small anchor may lack credibility.
- The European
Union also has specific prescriptions
about the allocation of seignorage.
The amounts are divided according
to the share of GDP of the various member countries.
For a discussion of the European
Central Bank policy objectives
and how this policy
relates to individual country shocks, see Alesina et al. (2001).
- A literature on Latin America, prompted mostly by a paper by
Gavin and Perotti (1997),
has also shown that fiscal policy has the wrong cyclical properties.
That is, surpluses
tend to appear during recessions, and deficits during expansions.
312
- ALESINA, BARRO, & TENREYRO
4. Data and
Methodology
4.1 DATA DESCRIPTION AND SOURCES
Data on outputs
and prices
come from the World Bank's World Develop-
ment Indicators (WDI) and Penn World Tables 5.6. Combining
both
sources, we form a panel
of countries with yearly
data on outputs
and
prices
from 1960 to 1997 (or, in some cases, for shorter periods).
For out-
put,
we use real per capita
GDP
expressed
in 1995 U.S. dollars. To com-
pute
relative prices,
we use a form of real exchange
rate relating
to the
price
level for gross
domestic products.
The measure is the purchasing-
power parity (PPP) for GDP divided by
the U.S. dollar exchange
rate.
In the first instance, this measure gives
us the price
level in country
i
relative to that in the United States, Pi,t/Pust.
We then compute
relative
prices
between countries i and j by dividing
the value for country
i by
that for country j.
Inflation is computed
as the continuously compounded
(log-difference) growth
rate of the GDP deflator, coming from WDI.
Bilateral trade information comes from Glick and Rose (2002), who in
turn extracted it from the International Monetary
Fund's Direction of
Trade
Statistics. These data are expressed
in real U.S. dollars.'
To compute
bilateral distances, we use the great-circle-distance algo-
rithm provided by Gray (2002). Data on location, as well as contiguity,
access to water, language, and colonial relationships
come from the CIA
WorldFact Book2001. Data on free-trade agreements
come from Glick and
Rose (2002) and are complemented
with data from the World Trade Orga-
nization Web page.
4.2 THE COMPUTATIONOF COMOVEMENTS
We pair
all (^) countries and calculate bilateral relative prices, Pi^
/ Pj.
(This ratio measures
the value of one unit of country
i's output
rela-
tive to one unit of country j's output.)
This procedure generates 21,
(207 x 206/2) country pairs
for each year.
For every pair
of countries,
(i, j), we^ use^ the annual^ time^ series^ {ln(Pit/P,j)}t97 to compute
the
second-order autoregression15:
- Pi = (PPP of GDP) / (ex. rate) measures how many
units of U.S. output
can be purchased
with one unit of country
i's output,
that is, it measures the relative price
of country
i's
output
with respect
to that of the United States. By definition, this price
is always
1
when i is the United States.
- Glick and Rose (2002) deflated the original
nominal values of trade by
the U.S. consumer
price index, with 1982-
= 100. We use the same index to express
trade values in
1995 U.S. dollars.
- We use fewer observations when the full time series from 1960 to 1997 is unavailable.
However, we drop country pairs for which fewer than 20 observations are available.
OptimalCurrency
Areas ?
In Pit = bo + bl n
Pjt Pj,t-1^ Pij,t-
The estimated residual, t,i,j, measures the relative price
that would not
be predictable
from the two prior
values of relative prices.
We then use
as a measure of (lack of) comovement of relative prices
the root-mean-
square
error:
fp^/
1 T
VP,
\IT-
t
The lower VPij,
the greater
the comovement of prices
between countries
i and
j.
We proceed analogously
to compute
a measure of output
comovement.
The value of VYij
comes from the estimated residuals from the second-
order autoregression
on annual data for relative per capita
GDP:
In
Yi = Co + C
In + C
In
Y
utij.
Yjt Yj,t-l Yj,t-
The estimated residual utij
measures the relative output
that would not
be predictable
from the two prior
values of relative output.
We then use
as a measure of (lack of) comovement of relative outputs
the root-mean-
square
error:
1T
VYij
t
Ui
t=l
The lower VYii,
the greater
the comovement of outputs
between countries
i and j.
For most countries all of the data are available. We exclude from the
computation
of comovements country pairs
for which we do not have at
least 20 observations. Note that this limitation implies
that we cannot in-
clude in our analysis
most of central and eastern Europe,
a region
in which
some countries are likely
clients of the euro.
OptimalCurrency
Areas ?
Table 1 MEAN ANNUAL INFLATION
RATE1970-1990a
Region
Rate(%/yr)
High-Inflation
Countriesb
Nicaragua
1168
Bolivia 702
Peru 531
Argentina
Brazil 288
Vietnam 213
Uganda
Chile 107
Cambodia 80
Israel 78
Uruguay
Congo,
Dem. Rep.
Lebanon 44
Lao PDR 42
Mexico 41
Mozambique
Somalia 40
Turkey
Ghana 39
SierraLeone 34
All
Industrial Countriesc
Developing
Countriesc
Africa
Asia
Europe
Middle East
WesternHemisphere
aBased on GDP deflators.Source:WDI2001.
bThisgroupincludesonly countrieswith 1997 population
above (^) 500,000.Rankedby inflationrate.
c Unweightedmeans.
flation rate (22%) resulted from a long period
of moderate, double-digit
inflation.
Tables 3, 4, and 5 list for selected countries and groups
the average
trade-to-GDP ratios16over 1960-1997 with three potential
anchors for cur-
rency
areas: the United States, the euro area (based on the twelve mem-
- The trade measure is equivalent
to the average
of imports
and exports.
Glick and Rose's
(2002) values come from averaging four measures of bilateral trade (as reported for im-
ports and exports by the partners on each side of both transactions).
316 *^ ALESINA, BARRO, & TENREYRO
Table 2 INFLATION-RATE VARIABILITY
1970-1990a
Region Variability(%/yr)
Countries with High Inflation Variabilityb
Nicaragua
3197
Bolivia 2684
Peru 1575
Argentina
749
Brazil 589
Chile 170
Vietnam 160
Israel 95
Cambodia 63
Uganda
63
Mozambique
52
Somalia 50
Oman 46
Lebanon 41
Kuwait 38
Uruguay
38
Guinea-Bissau 37
Mexico 37
Guyana
36
Congo,
Dem. Rep
36
Industrial Countriesc
All 4.
Developing
Countriesc
Africa 13.
Asia 14.
Europe
Middle East 28.
Western Hemisphere
a Standarddeviation of annual inflationrates, based on
GDP deflators.Source:WDI2001.
b Thisgroupincludesonly countrieswith 1997population
above (^) 500,000.Rankedby standarddeviationof inflation.
c Unweightedmeans.
318? ALESINA, BARRO, & TENREYRO
Table 4 AVERAGE TRADE-TO-GDP
RATIO WITH THE EURO
12, 1960-1997a
Region
Ratio (%)
High
Trade-Ratio Countriesb
Mauritania 34.
Congo, Rep.^
Guinea-Bissau 27.
Cote d'Ivoire 24.
Algeria
Belgium-Lux.
Gabon 23.
Togo
Nigeria
Tunisia 20.
Gambia, The^ 20.
Senegal
Comoros 19.
Netherlands 18.
Oman 17.
Cameroon 17.
Congo,
Dem. Rep.
Slovenia 16.
Angola
Syrian
Arab Republic
Industrial Countriesc
All 7.
Developing
Countriesc
Africa 14.
Asia 4.
Europe
Middle East 11.
Western Hemisphere
aTrade is the averageof importsand exports.(Im-
ports
is the averageof the values reportedby the
importer
and the exporter.Idem for exports.)Av-
eragesare
for 1960-1977(when GDP data are not
available,the^ averagecorrespondsto the^ periodof
availability).
Source:Glick& Rose (tradevalues);
WDI2001(GDP).Fora Euro country,the trade
ratiosapply to the other 11 countries.
b This group includes^ only countries^ with^1997
populationabove
(^) 500,000.
c Underweightmeans.
Optimal CurrencyAreas?
319
Table 5 AVERAGE TRADE-TO-GDP
RATIO WITH JAPAN,
1960-1997a
Region
Ratio (%)
High-Trade-Ratio Countriesb
Oman 16.
United Arab Emirates 15.
Panama 14.
Singapore
Kuwait 9.
Malaysia
Papua
New Guinea 9.
Bahrain 8.
Saudi Arabia 8.
Hong Kong,
China 7.
Indonesia 7.
Swaziland 6.
Thailand 5.
Gambia, The^ 5.
Mauritania 5.
Iran, Islamic Rep. 5.
Philippines
Korea, Rep.
Nicaragua
Fiji
Industrial Countriesc
All (^) 0.
Developing
Countriesc
Africa 1.
Asia 5.
Europe
Middle East 6.
Western Hemisphere
a Trade is the average
of imports
and exports. (Im-
ports
is the average
of the values reported by
the
importer
and the exporter.
Idem for exports.)
Av-
erages
are for 1960-1997 (when GDP data are not
available, the average corresponds to the period of
availability).
Source: Glick and Rose (trade values);
WDI 2001 (GDP).
bThis group
includes only
countries with 1997
population
above 500,000.
c
Unweigted
means.
