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Is the Middle East an Optimum Currency Area? A Comparison of Costs and Benefits

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Abstract

This paper examines the macroeconomic costs and benefits of adopting a common currency for 13 Middle Eastern countries. Economic theory suggests that the main benefit is enhanced price stability, while the main cost is higher business-cycle volatility if the member country’s output is not sufficiently correlated with the area’s, as a whole. Using data from 1980–2005, the paper finds that the estimated cost and benefit measures exhibit substantial variability across the countries and are sometimes positively correlated. Moreover, focusing on the results for the last decade, it seems that many Middle Eastern countries (such as Bahrain, Kuwait, Libya, Oman, Qatar, Saudi Arabia, Syria and United Arab Emirates) have achieved remarkable convergence both in business-cycle synchronization and inflation outcomes.

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Notes

  1. See, for example, Fatás (1997), Angeloni and Dedola (1998), Furceri and Karras (2006a, b), Afonso and Furceri (2007).

  2. See, for example, Eichengreen (2002), Le Baron and McCulloch (2000), Edward and Magdenzo (2002).

  3. See, for example, Eicheingreen and Bayoumi (1996).

  4. See, for example, Karras (2006).

  5. For the only exceptions we are aware of, see Abed et al. (2003), Al-Bassam (2002), Al-Jasser and Al-Hamidy (2002) and Jadresic (2002).

  6. See Jadresic (2002).

  7. It is worthwhile to mention that inflation differentials have been used as arguments both for and against joining a monetary union. The traditional view presented by Haberler (1970) and others was that substantial initial inflation differentials would raise the cost of a union. The more recent credibility view (see, for example, Alesina et al. 2002) is that high inflation countries have the most to gain. The two views are not necessarily contradictory: membership may well mean a benefit for the high-inflation country itself, but an added cost for the other members.

  8. Also see Karras (2003). Very similar results can be derived from the “older” monetary policy model based on the work by Kydland and Prescott (1977), Barro and Gordon (1983), and Rogoff (1985), and used to evaluate the effects of monetary integration by Alesina and Grilli (1992), De Grauwe (1994), and Alesina and Wacziarg (1999). The main differences between these models and the present formulation are a more modern aggregate supply specification and a richer dynamic structure.

  9. This specification of the Phillips curve goes back to Calvo (1983). For more recent examples see Rotemberg (1987), Roberts (1995), and Gali and Gertler (1999).

  10. As first pointed out by Taylor (1979), there is also a trade-off between output variability and inflation variability, given here by \( {\text{Var}}{\left( {\pi ^{{{\text{IND}}}}_{i} } \right)} = a^{2}_{i} \lambda ^{2}_{i} {\left[ {\lambda ^{2}_{i} + a_{i} {\left( {1 - \beta \phi _{i} } \right)}} \right]}^{{ - 2}} \sigma ^{2}_{i} \): a low a reduces the volatility of inflation but raises that of output. See Fuhrer (1997).

  11. Once more, the equality of inflation rates under the Middle East common central bank follows from the assumption that the central bank uses the inflation rate itself as the instrument of monetary policy. If the instrument is the interest rate or the money growth rate, then these variables would be common across the states and inflation rates may differ according to money demand and IS curves. This wouldn’t change any of the conclusions drawn below, however, so the simpler specification is preferred here, as in much of the literature.

  12. Real GDP is expressed in PPP-adjusted constant 2,000 prices, and the Nominal exchange rate is expressed in terms of a country’s national currency per U.S. dollar.

  13. To conclude, it is worthwhile to point out that the countries with higher exchange-rate stability tend also to be the countries with lower inflation rates. This of course justifies our treatment of price stability and exchange rate stability as the same policy goal.

  14. Middle-East’s output is given by the total GDP in the Middle-East area.

  15. See the Appendix for a detailed comparison between the rank’s correlations.

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Acknowledgement

We wish to thank an anonymous referee for helpful comments and suggestions. Errors and omissions remain ours.

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Authors and Affiliations

  1. Department of Economics (M/C 144), University of Illinois at Chicago, 601 S. Morgan Street, Chicago, IL, 60607, USA

    Davide Furceri & Georgios Karras

  2. Department of Economics, University of Palermo, Palermo, Italy

    Davide Furceri

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  1. Davide Furceri
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  2. Georgios Karras
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Correspondence to Davide Furceri.

Appendix

Appendix

Table 4 Spearman’s rank correlation matrixes for syncronization
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Furceri, D., Karras, G. Is the Middle East an Optimum Currency Area? A Comparison of Costs and Benefits. Open Econ Rev 19, 479–491 (2008). https://doi.org/10.1007/s11079-007-9046-4

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