How important are different types of cross-country integration in a currency area?

The main problem with currency areas is that they have a common monetary policy but may be subject to country-specific shocks that require different central bank responses. In addition, the exchange rate between its members cannot serve as “shock absorber” because it is permanently fixed. The well-known theory of optimum currency areas (R. A. Mundell (1961) “A Theory of Optimum Currency Areas” AER) points out several reasons why a currency area may work better for some groups of countries (or states) than for others. In principle, a currency area in which countries are highly integrated through cross-country labor mobility, trade and financial linkages, and fiscal transfers will respond better to country-specific shocks than a currency area whose members are less integrated. However, the relative importance of these different factors has not been evaluated quantitatively. For example, is the Eurozone’s main problem the fact that labor mobility across countries is low? Or is lack of labor mobility not very important as long as there are cross-country fiscal transfers or closer trade relationships? The objective of this study is to use a dynamic stochastic general equilibrium (DSGE) model of currency areas to answer these questions. The model includes two countries that form a currency area and also interact with the rest of the world. The response to different country-specific supply and demand shocks is simulated under different assumptions to find out which factors matter the most to make a currency area work better. The answers from this study may help Eurozone policymakers decide where they should allocate their efforts in order to increase the resilience of that currency union. My analysis should also be useful for any country considering joining a currency area.