How Much Can the Monetary Policies of Small Open Economies Neighbouring the Eurozone Be Independent?

Božena Kadeřábková and Ondřej Bednář

European Journal of Interdisciplinary Studies, 2022, issue 02

Abstract: This paper examines the argument that a small open economy with goods and service markets integrated into a major currency block has decreased autonomy over its monetary policy. The idea is derived from Optimum Currency Area theory (OCA), which tries to answer the question of what economic area is supposed to share one common currency. The main cost of joining a common currency area is a loss of independent monetary policy of the economy. Independence of monetary policy can be interpreted as the ability to set interest rates autonomously of the international interest rates. The de facto independence of an economy is strongly influenced by its size and market integration as R. McKinnon famously noted. Therefore, the paper's question is: do the countries abstaining from joining the Eurozone have a truly independent monetary policy? If the independence of their monetary policy is low, then the cost of joining the Eurozone is also low. The topic is highly relevant for the examined countries as five of them are legally bound to accept Euro. Therefore, the costs of losing "not so independent" monetary policy should not be so high. We analyze the data if the European countries with sovereign currency follow the monetary policy of the Eurozone and the United States. As previous literature stated, the independent monetary policy sets the interest rates to impact the economy's internal balance. On the other hand, if the central bank uses its interest rate tool to affect the exchange rate, then the monetary policy is not so independent. The results show that the monetary authorities of the United Kingdom, Sweden, and Denmark follow the lead of the European Central Bank much more evidently than the Czech Republic, Hungary, Poland, and Romania.

Keywords: monetary policy; OCA; common currency; market integration (search for similar items in EconPapers)
JEL-codes: E02 E47 E50 (search for similar items in EconPapers)
Date: 2022
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