The Optimal Currency Area in a Liquidity Trap

Abstract

Open economy macro theory says that when a country is subject to idiosyncratic macro shocks, it should have its own currency and a flexible exchange rate. But recently in many countries policy rates have been pushed down close to the lower bound, limiting the ability of policy-makers to accommodate shocks, even in open economies with flexible exchange rates. In this paper, we show that if the zero bound constraint is binding and policy lacks an effective `forward guidance' mechanism, a flexible exchange rate system may be inferior to a single currency area, even when there are country-specific macro shocks. When monetary policy is constrained by the zero bound, under independent currencies with flexible exchange rates, the exchange rate exacerbates the impact of shocks. Remarkably, this may hold true even if only a subset of countries are constrained by the zero bound, and other countries freely adjust their interest rates. In order for a regime of multiple currencies to dominate a single currency area in a liquidity trap environment, it is necessary to have effective forward guidance in monetary policy.