Optimal Currency Areas and Customs Unions: Are They Connected?

Abstract

This paper examines the link between currency areas and customs unions. The size of a bloc of countries practicing some form of co-ordination of monetary policy is limited by the incentive to free-ride that formation of the bloc creates. However, when the threat of a trade war is introduced, the stable size of the bloc increases. This suggests that a large currency area is more likely to emerge where it combines with a customs union, and that the stability of both currency area and customs union are closely related, because the threat of tariff penalties can enforce co-operation.

JEL Classification: F33, F42