Correlation and Cyclical Convergence in the Euro Zone *

This paper introduces the measure of instantaneous correlation to study the effects of a common currency on cyclical correlation and convergence in the euro zone. Conventional, backwardlooking measures of correlation are not appropriate for a dynamic currency union. An accurate measure of cyclical correlation must account for the change in economic structures due to a common currency and the convergent effects of these changing structures. In addition to accurately reporting cyclical correlation, the measure of instantaneous correlation allows the convergent effects of increased trade, demand spillovers and industrial specialization to be isolated and measured through counterfactual situations. * I would like to thank Andrew Hughes Hallett, Mario Crucini, and William Hutchinson for many helpful comments and suggestions, and Claire Larson for helping in the editing process. a Department of Economics, Vanderbilt University, VU Station B #351819, Nashville, TN 37235-1819, USA, Tel.: +1 615 322 2871; fax: +1 615 343 8495; e-mail address: [email protected]. When the euro became the common European currency, the national central banks of the euro zone ceded monetary independence to the European Central Bank. Each country agreed that a monetary policy should be adopted that is best for the entire euro zone, even if it is not best for their own individual economies. Since governments use monetary policy to smooth business cycle fluctuations and stabilize economies, the loss of an independent monetary policy puts the country at risk for real instability in the short and medium term. This is the cost of a common currency. When the various national governments approved the euro they believed the benefits of a common currency outweighed the costs. These benefits and costs are difficult to quantify and impossible to compare, but convergence towards a common European business cycle makes this comparison moot as the costs of a common currency tend towards zero. But will these costs tend towards zero? Will the euro in fact induce cyclical convergence between the euro zone