Uncertainty, Currency Areas and the Exchange Rate System

Abstract

The uniqueness of international finance reflects the multitude of national currencies. Both benefits and costs are attached to separate national currencies. Each country with its own currency can pursue an independent monetary policy. Various costs are incurred with the foreign transactions associated with international payments. These costs are avoided in a unified currency world, since there is no exchange market, but the advantages of independent monetary policies are not attained. The trade-off between the advantages of independent monetary policies and the costs of exchange markets involves optimization, both of the number and scope of national currency areas and also (of greater immediacy) in the type of exchange rate system-the choice between pegged rates and floating rates and among various types of pegged systems. The frequent exchange crises in recent years have indicated that the International Monetary Fund system of adjustable pegs has not been functioning well. National authorities have been reluctant to change the parities; variations in ad hoc controls on foreign payments have compensated for sticky exchange pegs. These controls constitute selective changes in exchange rates, so that a system of multiple exchange rates has resulted. The rationale for the commercial policy approach to international adjustment is that the political costs associated with changes in the exchange rate are avoided. Floating exchange rates are sometimes viewed as a way to attain greater flexibility and yet avoid the political costs associated with changes in parities. Other proposals for increased flexibility seek to retain elements of the pegged system so as to minimize uncertainty in the exchange market and the likelihood of disorderly national behaviour in it. The proposals for wider support limits, crawling pegs and sliding bands differ in terms of the frequency and method by which the parity is changed and the width of the support limits around the parity.' This paper identifies economic criteria which provide a basis for