Evaluating BRICS as an optimum currency area: insights from SVAR modeling

Abstract

The study evaluates the feasibility of BRICS (Brazil, Russia, India, China, and South Africa) countries to form an Optimum Currency Area (OCA) through the analysis of shock correlation within the OCA framework. Employing a structural vector auto regression (SVAR) model proposed by Blanchard and Quah, the analysis encompasses both external and domestic shocks affecting individual countries. The study employs four variables: world real GDP, domestic real GDP as a proxy for output, the real effective exchange rate, and the inflation rate as a proxy for price level, to estimate the shocks. Subsequent analysis includes ANOVA, impulse response function (IRF), and variance decomposition to discern shock magnitudes, adjustment dynamics, and underlying determinants of variability. Empirical results show that BRICS countries display symmetric responses to external shock, however, with overall different sources of variation in the responses to domestic supply, demand, and monetary shocks. The results of the analysis using the ANOVA test, IRF, and variance decomposition also highlight the nuanced disparities across BRICS countries in terms of demand, and monetary shocks, indicative of differences in transmission mechanisms and policy responses. The study underscores the implication of aligning exchange rate mechanisms and monetary policies in facilitating the convergence of shock levels, thereby fostering economic stability among BRICS countries.

Keywords

• Optimum currency area (OCA)
• structural vector auto regression (SVAR)
• shock dynamics
• BRICS
• Development Economics
• International Economics