„The OCA Theory and its Application to Central and Eastern European Countries“ Zuzana Kucerova Technical University of Ostrava Faculty of Economics

2 Contents 1.Introduction 2.The OCA Theory and its Criteria 3.The Cost and Benefits of Fixed Exchange Rates 4.The Endogeneity of the OCA Criteria 5.Eastern EMU Enlargement in the context of the OCA Theory 6.Conclusions

3 The OCA Criteria R. A. Mundell (1961) The factor mobility R. I. McKinnon (1963) The degree of economic openness P. B. Kenen (1969) The diversification of production and consumption

4 R. A. Mundell (1961, p. 663) „If factor mobility is high internally and low internationally, a system of flexible exchange rates based on national currencies might work effectively enough. But if regions cut across national boundaries or if countries are multiregional, then the argument for feasible exchange rates is only valid if currencies are reorganized on a regional basis.“

5 R. I. McKinnon (1963, p. 719) „If we move across the spectrum from closed to open economies, flexible exchange rates become both less effective as a control device for external balance and more damaging to internal price level stability. In fact, if one were worried about unwanted speculative movements in a floating exchange rate in case of an open economy, a policy of completely fixed exchange rate would be optimal.“

6 P. B. Kenen (1969, p. 54) „Fixed rates … are most appropriate – or least inappropriate – to well-diversified national economies. Ex ante, diversification serves to average out external shocks and, incidentally, to stabilize domestic capital formation. Ex post, it serves to minimize the damage done when averaging is incomplete.“

7 Other OCA Criteria Price and wage flexibility Similarity of supply and demand shocks Fiscal transfers Financial market integration Similarity of inflation rates

8 The Costs and Benefits of Fixed Exchange Rates The GG-LL Model Degree of economic integration Gains and losses from joining a currency area GG LL A 1

9 The Endogeneity of the OCA Criteria endogenous „… a naive examination of historical data gives a misleading picture of a country’s suitability for entry into a currency union, since the OCA criteria are endogenous.“ Frankel and Rose (1998)

10 The OCA Line Degree of economic integration Correlation of business cycles OCA line Good candidates for a common currency Countries that should float independently

11 The Endogeneity Hypothesis Degree of economic integration Conventional View of an OCA Gains and losses from joining a currency area L L G G Degree of economic integration Correlation of business cycles OCA line EMU 1 2 The Endogeneity Hypothesis EU 3

12 The Specialisation Hypothesis Alternative View of an OCA Degree of economic integration Gains and losses from joining a currency area L L G G Degree of economic integration Correlation of business cycles OCA line EMU 1 2 The Specialisation Hypothesis

13 Eastern EMU Enlargement in the Context of the OCA Theory Some possible approaches: 1.Correlation of supply and demand shocks 2.Correlation of business cycles 3.Convergence of monetary policies 4.The OCA index

14 1. Correlation of Supply and Demand shocks SVAR models of output growth and inflation Bayoumi – Eichengreen (1993)Bayoumi – Eichengreen (1993)  Does EMU constitute an OCA? Frenkel et al. (1999), Horvath (2002)Frenkel et al. (1999), Horvath (2002)  correlation between CEECs and Germany or France Fidrmuc – Korhonen (2001), Weimann (2002)Fidrmuc – Korhonen (2001), Weimann (2002)  correlation between CEECs and Eurozone Babetski et al. (2002)Babetski et al. (2002)  correlation between CEECs and Germany or EU-15

15 2. Correlation of Business Cycles Boone – Maurel (1998), (1999)Boone – Maurel (1998), (1999)  correlation between CEECs and Germany or EU-15 Korhonen (2001)Korhonen (2001)  correlation between CEECs and Eurozone Fidrmuc (2001)Fidrmuc (2001)  correlation between CEECs and Germany, intra-industry trade

16 3. Convergence of Monetary Policy Nominal convergence Brada – Kutan (2001)Brada – Kutan (2001)  convergence of base money between CEECs and Germany, a cointegration method Brada et al. (2002)Brada et al. (2002)  convergence of base money, M2, CPI and industrial output between CEECs and Germany or France, a rolling cointegration method

17 4. OCA index Structural convergence Bayoumi – Eichengreen (1997)Bayoumi – Eichengreen (1997) – authors of the OCA index SD (e ij ) = β 0 + β 1 SD(Y i – Y j ) + β 2 DISSIM ij + β 3 TRADE ij + β 4 SIZE ij SD (e ij ) SD (e ij ) is the standard deviation of the change in the logarithm of the end-year bilateral exchange rate between countries i and j; SD(Y i – Y j ) SD(Y i – Y j ) is the standard deviation of the difference in the logarithm of real output between i and j; DISSIM ij DISSIM ij is the sum of the absolute differences in the shares of agricultural, mineral, and manufacturing trade in total trade; TRADE ij TRADE ij is the mean of the ratio of bilateral exports to domestic GDP for countries i and j; SIZE ij SIZE ij is the mean of the logarithm of the two GDPs measured in U. S. dollars.

18 Conclusions The OCA theory is a suitable framework for discussing the process of monetary integration in Europe. A big amount of approaches to assessing the process of monetary integration in the context of the OCA theory. Different results of empirical studies. Possible reasons: different methodology, differences in the length of sample period, diverse sample of analysed countries …