Lecture 8

Macroeconomic Policy Goals in an Open Economy

Optimal Currency Area and Dierent Exchange Rate
Regimes
Internal and External balance in open economies.
Internal Balance: requires the full employment of coun-
try's resources and domestic price stability.
External Balance: requires balance in its current ac-
count.
Monetary and scal policies in open economy should
take into account both dimensions in the formulation
of economic policy in open economy.
-between 1948 and 1973 we had xed exchange rate
regime with major currencies being pegged to the
US dollar.(fundamental disequilibrium allowed deval-
uation or revaluation of the exchange rate).
Discussion in 1950s and 1960s around two objectives:
achieving full employment along a stable level of prices
and achieving equilibrium in the balance of payment
(balance demand and supply for their currencies).
-changes in scal and monetary policy which aim to
inuence the level of aggregate demand in the econ-
omy are termed expenditure changing policies. Poli-
cies that change the composition of spending between
domestic and foreign goods are known as expenditure
switching policies.
-Swan diagram captures policy's objectives in open
economy.
Internal Balance:
Y
f
= C

Y
f
T

+I +G+CA

EP

P
; Y
f
T
!
where Y
f
is the full employment level of output.
a)Fiscal expansion stimulates aggregate demand and
causes output to rise.
b)Devaluation of the currency makes domestic goods
and services cheaper relative to those sold abroad and
increases demand and output.
External Balance:
CA

EP

P
; Y
f
T
!
= X
where X is the target for the current account balance
a) Fiscal expansion worsen the current account;
b) Devaluation improves the current account;
We can have 4 zones:
Zone 1: Overemployment and current account surplus
Zone 2: Overemployment and current account decit
Zone 3: Underemployment and current account decit
Zone 4: Underemployment and current account sur-
plus
Suppose we are in zone 2 in which the economy experi-
ence overemployment and a current account decit. If
the authorities maintain a xed exchange rate regime
and try to reduce the current account by cutting back
real domestic expenditure would bring the economy
into an equilibrium with unemployment. On the other
hand a devaluation policy will imply a reduction of the
current account decit but would imply a overemploy-
ment.
We cannot use one instrument to achieve two targets.
To move the economy towards the internal and exter-
nal equilibrium, the authorities need to deate the
economy and undertake a devaluation by appropriate
amounts.
Theory of Optimum Currency Area (Mundell, AER
1961)
Denition of currency area: is a zone where the ac-
cepted means of payment consists either of a single,
homogenous currency or of two or more currencies
linked by an exchange rate which is xed irrevocably.
Need of a framework to think systematically about
costs and benets of a joining a currency area.
We also analyse the factors that determine how the
currency area works.
Benet of Currency Area: (mostly microeconomic in
nature)
-existence of multiple currency imposes costs on in-
dividual agents or society as a whole. (think about
bid-ask spread in currency conversions)
-reducing exchange rate volatility (cost of uncertainty):
argument most often used is that uncertainty damage
the volume of real ows of trade and investment.
-improved coordination of monetary policy: in a world
of oating exchange rates, countries do not take into
account the spillover eects that arise from their pol-
icy actions and they try to use them in a sub-optimal
way from a global perspective.
Cost of Currency Area: (mostly macroeconomic in
nature)
These costs are not related to the nature of equilib-
rium under the two regimes but are related to the ad-
justment process following a disequilibrium situations
in the two cases (xed versus oating).
-main cost is represented by the lost of monetary pol-
icy independence;
The cost of relinquishing monetary policy indepen-
dence depends critically on the nature of the shocks
and the characteristics of the economy that we are
considering.
-asymmetric shocks;
-stickiness in wage and prices
-labour mobility across countries;
-openness of the country;
Consider an asymmetric shock that hit dierently two
countries A and B. Assume that both country A and
B dislike ination and unemployment. We consider
an asymmetric preference shock that determines an
increase for the goods produced in country A and a
reduction in demand for goods produced in B.
This will generate ination in country A and unem-
ployment in country B .
Under a oating regime: appreciation of the nominal
exchange rate (country A) in order to restore com-
petitiveness; as a consequence country A will see its
exports falling and country B will see its exports rising.
Under a xed exchange rate regime: the domestic
economy loses reserves and the excess demand for
money put downward pressure on product prices and
pushes up interest rates; if prices falls faster than nom-
inal wage then real wages increases and unemploy-
ment will increase. The automatic stabilising mech-
anism does not operate and country A is left with
ination while country B is left with unemployment.
If country A tends to deate by reducing money sup-
ply then given the exchange rate regime, country B
will also have to reduce its money supply making the
unemployment problem worsening.
Note that this problem would not arise if shocks are
symmetric. If demand is high in both countries both
central banks can reduce money supply this increasing
the common interest rate and avoid ination.
The argument in favor of a oating exchange rate
regime presupposes that labor is immobile internation-
ally.
Suppose that labor is mobile internationally: then
even with xed exchange rate regime equilibrium can
be restored without transitional unemployment. Un-
employed workers can migrate towards countries where
they can be absorbed into employment. Labor mobil-
ity might obviates the need for exchange rate exibil-
ity.
Mundell concluded that the optimal zone for single
currency was determined by an area in which labour
was willing and able to move freely =)small currency
zone
McKinnon argument points toward larger currency zones:
one factor that is crucial in determining the role of the
exchange rate as an automatic stabiliser is given by the
degree of openness of the economy. In a large econ-
omy in which imports and exports are only a small
fraction in the consumption basket, then the direct
eect of a depreciation is going to be small (country
B will not see its export rising if the exchange rate
depreciates).
Asymmetric shocks are more likely to occur if the
member countries spcialise in dierent sectors because
movements in international prices aect them dier-
ently.
Conclusion: in determining the choice of joining a
currency area, need to evaluate costs and benets as
outlined above.