International Monetary Relations — 1: Exchange Rate Regimes

Abstract

There are two main factors determining whether the balance of payments adjustments of some geographic area would be more easily handled as a region within a common currency area or as an independent country with a separate currency and a potentially variable exchange rate. The first of these is size. The smaller the size of the region, the easier it is for it to adjust within a common currency area and the greater the difficulty of making an independent command over monetary and exchange-rate policies effective. Larger countries may enjoy certain economies of scale (for example in government itself) and the existence of large currency areas does eliminate the need for continuous currency exchanges within the area. On the other hand, a region which cannot adjust its exchange rate in response to external shocks will have to bear additional adjustment costs in terms of disturbances to labour markets (e.g., migration and unemployment) and large shifts in incomes and wealth. If the prime goal is internal stability, it would seem that the greater the number of separate currencies the better. However, simple observation shows that single currency areas range from huge countries down to very small states. This diversity suggests that the costs of diverging from the optimally-sized currency area are not sufficient to outweigh other more powerful forces shaping political boundaries.