Do Austria And Germany Form An Optimum Currency Area?

Abstract: The paper focuses on consequences that a Common Currency Area imposes on the wage and price formation in a small open economy. Optimum Currency Areas (OCA) can be defined in many ways but the concept can be simplified to a high degree of labor mobility and real wage flexibility. Assuming an OCA consists of several regions this implies that shifts in relative prices among those regions should not induce movements in regional unemployment or inflation but either migration or real wage adjustment. The presence of an OCA between Austria and Germany is of special interest because the Austrian schilling can be regarded as pegged to the deutsche mark since the 1950's and the European Monetary Union forces not only small open economies to adjust their price and wage formation in accordance with stable member countries. Using a structural VAR approach, shocks to the nominal effective exchange rate are interpreted as shifts in relative prices. A test for an OCA between both countries looks on effects that exchange rate shocks have on unemployment and real wages in the tradables and nontradables sectors of a small open economy.