Abstract
AbstractIn a rational expectations model, wages and prices should respond more to shocks in currency unions than under adjustable pegs because of the absence of exchange rate adjustment. This is an aspect of the endogeneity of the optimum currency area criteria that has been largely ignored. Empirical evidence from three currency unions tends to suggest some degree of endogeneity of price flexibility, but the rate of adjustment is slow. Self‐selection into currency unions by countries with naturally greater price flexibility does not appear to be a significant factor.
Highlights
In a rational expectations model, prices exhibit more flexibility in response to shocks in a currency union than under an adjustable peg, but the real exchange rate adjusts less and output is more affected by the shock, because the nominal exchange rate cannot perform the role of a shock absorber
EMPIRICAL RESULTS After some preliminary data analysis, some regression results are presented for price adjustment under different exchange rate regimes, based on equation (13) or variants
Our theoretical model predicts that agents change their behaviour because of the exchange-rate commitment of a currency union, so that price rigidity is endogenous to the exchange rate regime
Summary
Robert Mundell opens his seminal 1961 paper on optimum currency areas with the following statement: “[I]t is patently obvious that periodic balance of payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the terms of trade from fulfilling a natural role in the adjustment process.” The literature has emphasised the importance of international linkages between regions through the extent of trade, symmetry of shocks, labour mobility and fiscal transfer mechanisms as criteria for a currency union. Frankel and Rose (1997) added a new twist to the debate by noting the endogeneity of some of these criteria, showing that the formation of a currency union itself tended to increase intra-union trade and the symmetry of shocks. Mundell’s paper, as the quote above makes clear, is not about fixed exchange rates as such, but about fixed exchange rates combined with rigid wages and prices This second element has figured relatively little in subsequent discussion, no doubt because the existence of these nominal rigidities is taken for granted. In a rational expectations model, as mentioned above and shown below, wage- and pricesetters should be more willing to adjust wages and prices under hard pegs, because the nominal exchange rate is known to be fixed. As the model predicts, price adjustment is somewhat greater, but still slow: a ten percent difference in the level of the real effective exchange rate is estimated to be associated with a relative price movement of less than one percent per annum, using consumer prices, and somewhat faster using GDP deflators.
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