April 17, 2014

Cross-Country Insurance Mechanisms in Currency Unions: An Empirical Assessment

Countries in a monetary union can adjust to shocks either through internal or external mechanisms. In this study, we quantitatively assess a number of relevant mechanisms suggested by Mundell’s optimal currency area theory for the EU, and compare them to the US states.
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For this purpose, we update a number of empirical analyses in the economic literature that identify (1) the size of asymmetries across countries and (2) the magnitude of insurance mechanisms relative to similar mechanisms and compare results for the European Monetary Union (EMU) with those obtained for the United States. To study the level of synchronization among EMU countries we follow Alesina et al. (2002) and Barro and Tenreyro (2007). To measure the effect of an employment shock on employment levels, unemployment rates and participation rates we perform an analysis based on Blanchard and Katz (1992) and Decressin and Fatas (1995). We measure consumption smoothing through capital markets, fiscal transfers and savings, using the approach by Asdrubali et al. (1996) and Afonso and Furceri (2007). To analyze risk sharing through a common safety net for banks we perform a rudimentary simulation analysis.