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On the feasibility of monetary union: Does it make sense to look for shocks symmetry across countries when none of the countries constitutes an optimum currency area?

  • Jean Louis, Rosmy
  • Brown, Ryan
  • Balli, Faruk

Usually, a monetary union is not considered feasible between countries if the correlations of shocks are positive but weak. This may not be so if the country with the larger output gap converges to full-employment equilibrium faster than the country with the smaller gap. We argue that common monetary policy can be destabilizing when countries' responses to non-monetary shocks are perfectly symmetric with a correlation of 1 but exhibit differing investment sensitivities to the real interest rate. We use Canada, Mexico and the United States to test the feasibility of a monetary union by documenting whether: 1) gross investments in Canada and Mexico are equally responsive to the real fund rate, and 2) Canada and Mexico's output growth and inflation respond differently to US monetary policy shocks and oil price shocks. This approach implicitly dictates whether the shocks themselves are symmetric or asymmetric. Using quarterly data and SVAR methodology, we conducted two layers of analysis. We estimated SVARs for the periods 1970–2008, 1970–1990 and 1991–2008 to find that a monetary union is feasible between Canada and the US for the first two sample periods. For Canada and Mexico, we find similar responses of output growth to US monetary policy shocks. We conducted further robustness tests by estimating two identified VARs with common US variables and oil prices for Canada and Mexico to assess commonality in responses to shocks with the US. These results affirm that a monetary union is also feasible between Canada and the US.

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Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 28 (2011)
Issue (Month): 6 ()
Pages: 2701-2718

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Handle: RePEc:eee:ecmode:v:28:y:2011:i:6:p:2701-2718
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30411

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