Rethinking Optimal Currency Areas

The classic optimal currency area criterion is that countries with more correlated shocks are better candidates to form a union. We show that when countries have credibility problems this simple criterion must be changed: Symmetric countries gain credibility when joining the union only when the shocks affecting credibility are not highly correlated. Our analysis provides a amended optimal currency area criterion that we argue is more relevant than the classic one. We illustrate our argument both for a reduced form model and for a relatively standard sticky-price general equilibrium model. We argue that our new criterion should lead to a rethinking of the massive amount of empirical work on optimal currency areas.