Criteria of the optimal currency area: an empirical analysis

Abstract

Using annual data of 37 countries for 2010-2018, the paper studies the relationship between the average GDP growth rate and several exogenous variables analyzed in the context of the Optimal Currency Area (OCA), such as openness for trade and capital flows, inflation and synchronization of the business cycles, based on the cross-section regression model. Similar relationships are estimated for the quarterly time series of Ukraine’s economy for 2010-2020. The paper argues that the GDP rate is positively related to both the openness to foreign trade and lower inflation, a result in line with the implications of the OCA theory. However, a similar stimulating effect of the capital inflows for Ukraine significantly differs from the opposite outcome obtained in the estimates of the cross-section regression for 37 countries. Our results mean that openness for trade is not excessive in Ukraine. While most countries have experienced a decline in the share of exports and imports in GDP since 2010, an upward trend in Ukraine, similar to the Central and Eastern European (CEE) countries, can be viewed in a favourable way. As there is an inverse relationship between the average GDP growth rate and initial GDP per capita, it is an argument in support of the neoclassical long-term growth models. It is clear that middle-income countries experience the convergence of income in line with the provisions of the neoclassical theory. However, net capital inflows do not play any role in the convergence process, thus rejecting one of the pillars of the neoclassical theory. For the cross-section estimates, no link between economic growth and business cycle synchronization with the main trade partner is detected. On the other hand, economic growth in Ukraine is closely related to the GDP dynamics in the Eurozone, being an extra argument in favour of the European integration process in general and the OCA theory in particular. It is worth noting that the exchange rate depreciation brings about a GDP slowdown in Ukraine. Such an outcome implies that any efforts to compensate for the worsening of the external conditions with an accommodating exchange rate policy seem to be counterproductive. Also, it argues in favour of stable exchange rate arrangements. In a conventional way, an increase in Ukraine’s lending rate is associated with a decrease in the GDP growth rate.