Optimal monetary policy in the monetary union: effects on business cycles Mehdi Pedram Economics Department, Alzahra University, Vanak Square, Tehran, Iran, 1993891176. E-mail: mehdipedram@alzahra.ac.ir; mehdi.pedram@aggiemail.usu.edu Abstract The difficulties of a common monetary policy in an economic and monetary union are well known where there are differences between the stage of the business cycles and inflation pressures. In this paper, I will show that in a simple open macro model and by using ‘weighted mean mechanism’ monetary authorities can employ a common monetary policy to synchronise diverging business cycles in the member states. 1. Introduction The Optimal Currency Area literature (Mundell, 1961) suggests that a prerequisite for a successful common currency zone is a substantial degree of convergence. The euro has been introduced into a zone that contains many disparities and differences. There is the argument that the creation of a single market with a single currency will generate forces of convergence. But Krugman (1991) has reinforced this view that more economic integra- tion and monetary union will force the member states to become more specialised, which creates divergence. Frankel and Rose (1997) argues that European integration will make economic struc- tures more similar among participating countries while Krugman (1993) asserts that it makes firms reallocate activities and increase specialisation. On the empirical side, Sapir (1996) shows that specialisation has remained constant after 1992 in Germany, Italy and the UK and has increased in France. Midelfart-Knarvik et al. (2000) shows that at the European level specialisation between 1970–1973 and 1980–1983 has become more similar, while from 1980–1983 onwards it became dissimilar. On the other hand, the macroeconomic literature stressed that countries’ sectoral specialisation is an important determinant of the international synchronisation of business cycles (Imbs, 2004). It is found that countries with similar sectoral production patterns tend to be more synchro- nised than those with different sectoral production patterns. Moreover, the impact of specialisation patterns on business cycles is sizeable and most of it is independent of trade or financial policy. The result also holds if sectors differ in their response to shock 90 © 2011 The Author. OPEC Energy Review © 2011 Organization of the Petroleum Exporting Countries. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.