Transcript Macroeconomics Chamberlin and Yueh

Macroeconomics
Chamberlin and Yueh
Chapter 14
Lecture slides
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Exchange Rate Regimes and
International Policy Coordination
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The Choice of Exchange Rate Regime
International Policy Coordination
Optimal Currency Areas
Is Europe an Optimal Currency Area?
Should the UK join the Euro?
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Learning Objectives
• Determine the advantages and disadvantages of
different exchange rate regimes, namely, fixed and
floating.
• Investigate the subject of international policy
coordination, as in an open economy, policies or
shocks specific to one country can be transmitted
into others.
• Understand the concept of optimal currency areas
(OCA), and recent examples such as the European
Monetary Union (EMU) and the establishment of a
single currency in Europe (the euro).
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The Choice of Exchange Rate
Regime
• What factors might determine whether or not policy makers
opt to fix the exchange rate at a given level against another
currency, or let it float, allowing its value to be determined
by market forces?
• The answer is essentially the regime that policy makers feel
will most realistically achieve their economic goals.
• Historically, the main goal of governments has been to
achieve high and stable economic growth. It is from high
long-term economic growth that living standards are
improved. The role of government is therefore to manage
the economy in order to engineer the conditions that will
best achieve this.
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The Choice of Exchange Rate
Regime
• Objectives:
– Exchange rate stability
– Price (inflation) stability
– Output (business cycle) stability
• An evaluation of the advantages and
disadvantages of each type of exchange rate
regime can be couched in terms of its ability
to meet these three objectives.
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Exchange Rate Stability
• The question of regime choice with respect to exchange rate
volatility is fairly trivial; it is obvious that a fixed regime
will win here.
• Fixed exchange rate regimes, however, only provide a
temporary mirage of exchange rate stability. If pressures
on a currency continuously build, then the policies required
to maintain a fixed exchange rate regime may start to have
painful effects on the domestic economy. In such situations,
policy makers may eventually decide to abandon the fixed
regime, at which point there can be very dramatic
movements in the currency.
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Price Stability
• A traditional reason for maintaining a fixed exchange rate is
in order to control inflation.
• UK membership of the Exchange Rate Mechanism (ERM)
basically involved fixing the pound against the Deutsch
Mark (DM), but was solely motivated to try and import low
levels of West German inflation. Mexico has recently tried
to fix the value of the Peso against the U.S. dollar, the aim
of which is to demonstrate a commitment to low inflation.
• There are two reasons why this is the case.
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Price Stability
• Firstly, and most obviously, once a country commits to
fixing their exchange rate they give up control of their
monetary policy.
• The Quantity Theory of Money argues that: Mv=PY.
• It is assumed that the velocity of circulation is fixed, and
that output is always at its equilibrium of full employment
level. In this case, it stands that:
• Changes in the money supply will have directly
proportional effects on prices.
%M  % P
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Price Stability
• Under a floating exchange rate regime, policy makers may
undertake a monetary expansion in order to stimulate the
economy. If there are some price rigidities, they may be
successful in raising output in the short run, but ultimately
the predictions of the Quantity Theory of Money hold true
in that output stays at the natural level and prices rise.
• In a fixed exchange rate regime, the policy maker forgoes
control of the domestic money supply. Any monetary
shocks would have to be immediately offset, and therefore
will have no consequence for prices.
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Monetary Expansion: Floating
Exchange Rate Regime
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Monetary Expansion: Fixed
Exchange Rate Regime
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Price Stability
• There is a second reason why fixed exchange rates might be a useful
tool for establishing low inflation.
• This is connected with the general maxim that inflation rates cannot
permanently differ between two nations who have fixed their exchange
rates. This will give the high inflation country an opportunity to import
the low inflation from the country with lower inflation.
• Membership of a fixed exchange rate regime can create and enforce
inflation discipline. Firms are unlikely to increase prices if they know
that the exchange rate will not depreciate in order to restore their
competitiveness and workers are unlikely to push for higher wages if
they know that the result of this will be lower competitiveness and
higher unemployment.
• As long as domestic inflation exceeds that from overseas, the domestic
economy will suffer a loss in competitiveness that pushes output below
its natural level.
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Higher domestic inflation: Floating
Exchange Rate Regime
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Higher domestic inflation: Fixed
Exchange Rate Regime
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Foreign Price Shocks: Floating
Exchange Rate Regime
• A foreign price shock would improve the relative
competitiveness of domestic products, shifting the ISXM
schedule outwards.
• The economy will move from point a to b, but return to a
almost immediately following the domestic exchange rate
appreciation. The exchange rate moves to insulate domestic
inflation from the overseas price shock.
• Remember from the theory of purchasing power parity
(PPP): %P  %E  %P
• The change in the domestic price level is approximately
equal to the change in the foreign price level and the change
in the nominal exchange rate. Hence, if
 %E  %P  , then %P=0.
• The exchange rate appreciation is sufficient to offset the
higher overseas price level.
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Foreign Price Shocks: Floating
Exchange Rate Regime
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Foreign Price Shocks: Fixed
Exchange Rate Regime
• Under a fixed regime, the economy will not experience the
insulating effect of exchange rate movements.
• Instead, the foreign price shock would have to be
accommodated by an expansionary monetary policy and
would be transmitted directly into domestic prices.
• This can once again be seen by looking at the relative PPP
equation: %P  %E  %P
• Under a fixed regime, it must be the case that %E=0 and
%P  %P 
• Therefore, although a fixed exchange rate regime may offer
the opportunity of importing lower inflation, the converse
must also be true in that it may also offer the opportunity
for other countries to export high inflation.
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Output Control
• When defending a fixed parity becomes excessively painful
in terms of domestic output and unemployment, then policy
makers may be all too willing to sacrifice it.
• The choice of exchange rate regime has consequences for
the stabilisation of output at its full employment level. This
primarily works through net exports, with movements in the
nominal exchange rate affecting competitiveness.
• The conventional wisdom is that a floating exchange rate
regime is more successful here, as the exchange rate will
simply change to offset any demand (ISXM) shocks that hit
a country.
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Increase in Foreign Prices: Floating
Exchange Rate Regime
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Increase in Foreign Prices: Fixed
Exchange Rate Regime
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Output Control
• We have now reached one conclusion, that flexible
exchange rate regimes are more successful at insulating the
domestic economy from demand shocks. However, it is
worth bearing in mind that not all shocks affecting output
are necessarily demand shocks; although it is reasonable to
argue that these are the most important. A monetary shock
will lead to a shift in the LM schedule, which via its effect
on the domestic interest rate, can have implications for
output.
• Therefore, it appears that a second valid conclusion is that
countries which are prone to monetary (LM) shocks are
more likely to be successful in stabilising output with a
fixed exchange rate regime.
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Brief Summary
• The advantages and disadvantages of each type of regime
have been vigorously discussed over the years.
• Conventionally, it is argued that fixed regimes are best at
achieving nominal (exchange rate and price) stability,
whereas floating regimes are better at dealing with real
(output, employment) disturbances.
• Global Applications 14.2 A Short History of Fixed
Exchange Rate Regimes
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International Policy Coordination
• As countries become increasingly open with respect to
international trade and capital flows, the linkages among
these countries will strengthen.
• This will reinforce the spillover and feedback effects of
shocks and policies in domestic economies.
• There are principally two mechanisms through which these
work: exchange rate movements, and aggregate demand.
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Exchange rate externalities
• This can be seen using the Mundell-Fleming model where
policy changes through the impact on the exchange rate has
a clear effect on other countries.
• The next figures represent the cases when a large country
unleashes a fiscal expansion. Panel (a) represents the
domestic economy, whereas panel (b) represents the rest of
the world.
• Some of the initial fiscal expansion has been transmitted
overseas through movements in the exchange rate.
Equilibrium world interest rates are higher because higher
income means higher demand for money.
• The expansionary monetary policy of the large country
generates a negative externality for the rest of world. The
large country gains higher output by depreciating its
exchange rate vis-à-vis the rest of the world and improves
its relative competitiveness.
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A large country unleashes a fiscal
expansion
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A large country unleashes a
monetary expansion
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Aggregate demand externalities
• Policy in one country can also directly spill over into others
through aggregate demand externalities.
• When capital mobility is high, as in the Mundell-Fleming
model, the exchange rate is the main source of externality
because it reacts quickly and spontaneously to changes in
interest rates.
• For this reason, it is easier to discern the effects of
aggregate demand externalities by assuming no capital
mobility.
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Fiscal Expansion by a Large
Economy
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Impact on the rest of the world
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Aggregate demand externalities
• The aggregate demand expansion in one country has spilled
over into the rest of the world. This position, though, is not
sustainable.
• From the above figures, it is clear that the expanding
economy is now running a trade deficit and the rest of the
world an offsetting surplus. The deficit country will begin
to run down its reserves, at which point the money stock
will contract. As the LM curve shifts upwards, the
economy will move to point c. The fall in output will offset
the initial increase in global demand, so the rest of the
world will experience a fall in export demand returning
their economies back to point a.
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Aggregate demand externalities
• Suppose, though, that all the countries in the world
unleashed an equal fiscal expansion. The following figure
represents the outcome for each country if they all expand
simultaneously.
• As output has increased in every country, all will experience
a rise in exports as well as the initial expansion in aggregate
demand.
• Therefore, countries can expand without running into trade
deficits as before, making the increase in output more
sustainable.
• This is an example of how coordinating policy can deliver a
mutually preferable outcome. As there are potentially very
important spillovers among different economies, it is
obvious that there might be some benefits from
coordinating economic policies.
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Fiscal expansion by all countries
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Optimal Currency Areas
• The logic behind the theory of optimal
currency areas (OCA) is very simple – it
just implies that an economic region is an
optimal currency area if the advantages of
adopting a single currency outweigh the
disadvantages.
• A basic cost-benefit analysis can help find
the answer to whether a country should join
an OCA or not.
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Benefits: The GG Schedule
• The most obvious benefits are the monetary efficiency
gains of a single currency. Trade can now occur
without the transactions costs and uncertainty of
dealing in different currencies. A single currency also
makes it easier to compare prices in different countries;
markets will then be more competitive and that would
be expected to result in higher welfare.
• It is difficult to quantify the exact size of these benefits,
but it seems plausible to argue that the gains to a
country from joining a monetary union will depend on
the degree of economic integration that country has
with the area.
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Benefits: The GG Schedule
• The GG schedule is drawn
as an upward sloping
schedule, where the
monetary efficiency gains
from joining a single
currency area rises with
the degree of economic
integration.
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Costs: The LL Schedule
• Once a country signs up to a single currency, it loses the
ability to use monetary policy and the exchange rate to
control the economy. This could result in an economic
stability loss.
• As all the countries in a single currency must have a
common interest rate and exchange rate, asymmetric shocks
become very difficult to correct.
• These losses are likely to fall as the degree of economic
integration rises. The more closely integrated two
economies are, the more likely that the shocks affecting one
country will spillover into the other, and therefore a
common policy response would be required. Also, the
greater the regional mobility of labour the better, as
following a shock, unemployed workers can simply migrate
to areas with jobs. In this case, the costs of not being able
to use a unique policy are diminished.
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Costs: The LL Schedule
• The LL schedule is a
downward sloping
function, which shows
that the economic
stability loss of joining
a single currency falls
with the degree of
integration.
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Optimal Currency Area or not?
• The answer, as already alluded to, is simply to see whether
the costs outweigh the benefits.
• Where the GG and LL schedules intersect defines the
critical level of integration: this is shown as X1.
• If the joining country is more integrated than this level, X>
X1, then the benefits from joining the single currency area
outweigh the disadvantages.
• Alternatively, at levels of integration below the critical
level, X< X1, losses exceed gains.
• An optimal currency area can therefore be thought of as a
region or area where economies are closely linked by trade
and have high factor mobility.
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Optimal Currency Area
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Is Europe an Optimal Currency
Area?
• There is a high degree of trade integration between the
member states of the European Union (EU).
• Typically, most nations export between 10 to 20 percent of
their output to other member countries.
• On average the sum of intra-union exports and imports
represents around 30% of GDP.
• The extent of intra-European trade suggests there are
substantial gains from monetary union.
• The second reported efficiency gain would come from
greater price competition, benefiting European consumers.
Once all prices are quoted in the same currency, it should be
easier for consumers to buy goods and services where they
are cheapest.
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Is Europe an Optimal Currency
Area?
• The main debate centres on the cost side.
• The true costs of giving up control of monetary policy and
an independent exchange rate will depend upon two factors.
• First, how likely are asymmetric shocks?
• Second, even if asymmetric shocks are a significant factor,
will there be other adjustment mechanisms that a country
can use?
• These two considerations will determine the position of the
LL schedule. If both are significant factors, then for every
level of economic integration the stabilisation costs of a
single currency will be higher and the LL schedule will shift
upwards. As a result, the area is less likely to be an OCA,
even with a relatively high level of economic integration.
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Position of LL Schedule
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Is Europe an Optimal Currency
Area?
• Therefore, much of the debate on whether or not Europe is an OCA lies
in the likelihood of different shocks, or a lack of flexibility, to deal with
them.
• Asymmetric Shocks: The euro area would actually be expected to be less
prone to asymmetric shocks than the regions of the U.S. The euro area
is a group of sovereign nations, each with a well-diversified production
sector. The U.S., however, has been a single market for a considerable
period of time during which a more acute degree of regional
specialisation has occurred.
• Blanchard and Wolfers (2000) do not find much evidence that one
country will be subject to an asymmetric shock. Instead, it is argued that
all nations face roughly the same shocks, but differences in labour
market institutions propagate these shocks differently, creating different
effects on unemployment.
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Correction Mechanisms: Flexibility
• Asymmetric shocks are not a problem so long as there is
sufficient flexibility to deal with them if and when they
occur.
• Wage and Price Flexibility
• Using the Mundell-Fleming model, we can see why high
wage and price flexibility may be important in the EMU. In
a monetary union, there is perfect capital mobility and a
common interest rate. Because there is no independent
monetary policy, there is no LM curve. Equilibrium is
where the horizontal BP curve intersects the ISXM schedule
at the full employment level of output.
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Negative AD Shock:
Mundell Fleming Model
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Correction Mechanisms: Flexibility
• Suppose a country suffers a negative aggregate demand
shock, as a result the ISXM curve shifts inwards and the
equilibrium level of output falls below the full employment
level. This would put downward pressure on wages and
prices, which would improve competitiveness and lead to
an improvement in output. Eventually, it is the adjustment
of prices and wages that restores output to the full
employment level.
• However, the speed at which this happens is crucial, and
obviously depends on the flexibility of labour and goods
markets. If these are inflexible, then correction will be very
slow implying that a shock can have long-lasting effects on
output.
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Index of labour market flexibility
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Overall Product Market Regulation
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Correction Mechanisms: Flexibility
• It is obviously clear that the EMU member countries tend to
perform very badly on this scale, especially in comparison
to the U.S. which is deemed to have a very flexible labour
market.
• In terms of overall product market regulation is reported,
the same conclusions are reached. The higher value of the
index implies a higher level of regulation, and an expected
lower level of flexibility.
• It is again clear that EMU member states perform relatively
badly, which raises fears of inadequate flexibility.
• Low nominal flexibility increases the stability costs
associated with a joining a monetary union. The would
shift outwards, so even at high levels of integration, the EU
may fail to be an optimal currency area.
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Correction Mechanisms: Flexibility
• Factor Mobility
• Even if wage and price flexibility are poor, problems can be
mitigated if the mobility of the factors of production, and in
particular labour, is high. In this case, unemployed workers
in one region can migrate to another in search of
employment.
• It is clear that mobility in EU countries is substantially
lower than in Japan and the USA.
People changing region of residence in 1986
(% of total population)
France
Germany
Italy
Japan
UK
U.S.
1.1
1.3
1.1
0.6
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2.6
3.0
Fiscal Policy
• An obvious solution to an asymmetric shock would simply
be to launch an offsetting expansive fiscal policy.
• Under monetary unions, and as is the case with EMU, all
national governments retain control of fiscal policy to some
extent, so surely it can be used to correct any shocks?
• This is true in theory, and fiscal policy is an important
correction mechanism in the USA. However, under the
auspices of EMU, policy makers face strong constraints on
their ability to use fiscal policy which will obviously hinder
its ability to act as a correcting mechanism.
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Fiscal Policy
• Part of the EMU treaty is the Stability and Growth Pact
(SGP). This requires government deficits to not exceed 3%
of GDP, and the total national debt not to exceed 60% of
GDP. Repeated failure to comply could result in a fine of
up to 0.5% of GDP.
• The rationale behind the SGP is due to the fear that under a
monetary union, there is an incentive for fiscal indiscipline
which can interfere in the efficient operation of monetary
policy.
• In a monetary union, there is only one interest rate. All
government bonds, wherever they are issued are
denominated in euros and there is one euro interest rate.
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Fiscal Policy
• If one nation runs an unsustainable debt, its risk premium
will be spread over the bonds issued by the n members of
the single currency, which would put upward pressure on
the union interest rate.
• As the effects of a fiscal expansion will be localised in the
country it was undertaken whereas the interest rate effects
will be shared around the union, there is an incentive to run
excessive deficits.
• Panel (a) describes the country undertaking the
expansionary fiscal policy. Panel (b) shows the effects on
other EMU members.
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Expansionary fiscal policy in EMU
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Fiscal Policy
• A counter argument to the SGP is that financial markets
should be efficient and sophisticated enough to deal with
the excessive deficits problem.
• If one country is running large deficits, then the interest rate
penalty should only apply to the bonds that the country
issues. Even though there is only one euro interest rate, the
risk premium on top of this could still vary from country to
country.
• In panel (a), a nation financing an expansive fiscal policy
by borrowing will see financial markets impose a risk
premium on its bonds. The rest of EMU, though, will be
exempt from this risk premium. So, as panel (b) shows, it
will be insulated from the effects of one nation’s excessive
deficits.
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Expansionary fiscal policy in EMU:
Localised Effects
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Fiscal Policy
• Proponents of the SGP do not believe this to be the case
because of bailouts. If one nation defaults on its debts, the
ensuing financial crisis will spillover on the rest of Europe.
• If one country defaults, then creditors in other countries will
lose out. This may lead them in turn to default on other
loans, or require the immediate liquidation of other assets,
with repercussions, such as a general banking collapse. The
effects on union output could be substantial and
widespread.
• For that reason, the logical action would be for the other
countries in the EMU to bail out the deficit nation. In this
way, the interest rate risk premium cannot be limited to just
one nation, it will be a problem shared by all.
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Fiscal Policy
• Part of the EMU constitution is the “no bail out clause.”
This suggests that if a country where to be in serious debt
problems, the other countries in EMU will not bail it out.
• The problem with this clause, though, is that it does not
constitute a credible policy ex post.
• If one country were to risk default, the optimal policy
would be to try and mitigate the effects of a financial crisis,
which could involve bail out.
• If financial markets accept this to be the only time
consistent policy (hence, the no bail out clause is time
inconsistent), then the rest of the euro area cannot isolate
itself from the excessive deficits of one nation.
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Fiscal Policy
• Fiscal policy in EMU suffers from two conflicting concerns
– the need for flexibility to deal with shocks, and also the
need to deal with the potential problems of excessive
deficits. The SGP is a very contentious part of EMU, and a
large body of opinion would argue that it is unbalanced in
these objectives. The requirements of the SGP are argued to
be too rigid.
• Government deficits are likely to be cyclical due to
automatic stabilisers. In a recession, the government
budget moves towards deficit, meaning that fiscal policy
becomes most constrained at precisely the point it is most
needed.
• The SGP, therefore, imposes a heavy deflationary burden on
Europe because policy must tighten in times of low growth.
The growth record of the EU is seen next.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
U.S. vs. EU-11 Growth (%)
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Fiscal Policy
• The operation of fiscal policy in the U.S. is much more
geared to the correction of asymmetric shocks.
• Due to its federal structure, the government can redistribute
income to states that are subject to negative shocks.
• It is often argued that a successful monetary union will
require some form of fiscal federalism.
• Given that deficits are cyclical, this would involve transfers
from surplus (high growth) to debtor (low growth)
countries.
• In this way, the effects of unsynchronised business cycles or
asymmetric shocks can be smoothed. Whether or not fiscal
federalism is politically workable in the euro area though is
a separate question.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Should the UK join the Euro?
• The theory of optimal currency areas plays a
central role in the debate as to whether or not
the UK should join the EMU.
• Specifically, the basis of this assessment
comes down to whether the UK is
adequately converged with the rest of EMU,
and that it has sufficient flexibility to deal
with asymmetric shocks.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Should the UK join the Euro?
• For a single monetary policy to be universally appropriate,
it must be the case that economies have achieved an
adequate degree of convergence.
• There are two strands to the convergence issue:
convergence in cycles and convergence in structures.
• Adopting a single currency implies the sacrificing of
monetary policy autonomy. Exchange rates disappear, and
an one-size-fits-all interest rate is applied across the entire
monetary union.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Should the UK join the Euro?
• Convergence in cycles refers to the synchronisation of
business cycles. An one-size-fits-all interest rate will be
problematic if different countries are in different stages of
the economic cycle. A nation experiencing slow growth
would require a loosening of policy, whereas those growing
strongly might require higher rates to control inflation.
Under these conditions, it would be impossible for one
monetary policy to satisfy the differing needs of each
economy simultaneously.
• It appears to be the case that historically the UK business
cycle is more strongly correlated with the U.S. than the
Euro area. As such, European levels of interest rates may
be inappropriate for the UK economy.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Should the UK join the Euro?
• There appears to be sufficient evidence to conclude that the
UK and Euro-11 business cycles are not sufficiently
convergent. However, even if an adequate degree of
cyclical convergence is achieved, the convergence test can
still subject to failure because there would be significant
structural differences between the UK and the rest of EMU
to make the possibility of future asymmetric shocks a major
cause for concern.
• Convergence in structures relates to the idea that economies
may have structural differences that will make a common
monetary policy infeasible. Different economies could be
subject to different shocks, or react in different ways to the
same shocks, or have different monetary policy
transmission mechanisms. In this case, the common
monetary policy itself can be the cause of asymmetric
shocks.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Should the UK join the Euro?
• Empirical evidence indicates that the monetary policy
transmission mechanism is much stronger in the UK than
the rest of Europe due to the structure of its housing market.
• The two most important are the relatively high proportion
of owner occupied hosing in the UK, and also the high
proportion that hold flexible rate mortgages.
• Interest rate changes will have a much more profound effect
on UK aggregate demand than in the rest of Europe because
mortgage debt represents a relatively large proportion of
GDP.
• This almost certainly means that even if the UK achieves
convergence in cycles with the rest of Europe, it would still
stand to strongly benefit by maintaining autonomy over
monetary policy.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Should the UK join the Euro?
• Flexibility
• The UK exhibits higher nominal flexibility than Europe.
This would imply that the UK is relatively well positioned
to adjust to asymmetric shocks. However, this may be a
problem as the UK’s flexibility does not appear to be
mirrored in the major EMU member states.
• Work by Blanchard and Wolfers (2000) argues that
differences in unemployment are not accounted for by
asymmetric shocks, but by asymmetric responses to
common or symmetric shocks because of differences in
labour market institutions. For example, if a common
negative shock hit all of Europe, then unemployment will
rise. Therefore, the UK will find itself in a position where it
requires less of a stimulus than other EMU states in order to
reinstall full employment.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Dynamic Nature of Optimal
Currency Areas
• A valid criticism of the OCA theory and evidence presented
so far is that it is very static. In assessing entry to a
monetary union, it is also necessary to consider the
dynamics that might result from the entry decision. A
simple way of analysing this was devised by Frankel who
derived the OCA line.
• Countries that are highly integrated and have high-income
correlations are more likely to successfully develop and
maintain an OCA. Strong trade links increase the monetary
benefits of a single currency, whereas high correlation of
incomes represents convergence and lower stability losses.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
OCA Line
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Dynamic Nature of Optimal
Currency Areas
• The OCA line essentially compares the costs and benefits of
adopting a single currency. However, these may change
over time, especially once a monetary union has been
established and a single currency adopted.
• Once a single currency has been established, the nature of
trade and income convergence might change. Almost
certainly, a single currency will increase the extent of trade
among the members of the single currency as transactions
costs are reduced. Whether or not this makes an OCA more
or less likely depends on the effect increasing openness has
on income correlation.
• One view by McCallum is that increasing openness leads to
more significant spillovers between countries and therefore
a higher degree of income correlation.
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Endogeneity of OCAs dominate
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
The Dynamic Nature of Optimal
Currency Areas
• However, an alternative hypothesis pushed by
Krugman is known as the specialisation hypothesis.
• Increasing trade leads to increasing specialisation
as nations seek to capture the welfare benefits
associated with comparative advantage.
• A more specialised industrial sector will in turn
reduce the correlation of income and increase the
possibility of asymmetric shocks.
• In this case, the dynamics of an OCA will
eventually lead to its own failure.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Endogeneity of OCA fails
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• We investigated three topics as to how policy makers
manage the international aspects of their economy. These
are the type of exchange rate regime, international policy
coordination, and monetary union. Over the last twenty five
years, these have been important considerations for most
developed nations.
• We looked at the two types of exchange rate regimes, fixed
and floating, and their respective advantages and
disadvantages. The choice of regime has been an ongoing
issue for the past century.
• We also considered the subject of international policy
coordination in terms of transmission of shocks and the
impact of global demand. The role of the U.S. in the global
economy was analysed.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Summary
• Finally, we covered optimal currency areas (OCA). With the
recent development of European Monetary Union (EMU)
and the establishment of a single currency in Europe (the
euro), this has been important.
• We examined several outstanding issues for OCAs,
including the single market in Europe and whether the UK
should adopt the euro.
Use with Macroeconomics
by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning