3  Optimal Currency Areas: The Traditional Literature

“I would suggest that the issue of optimum currency areas, or, more broadly, that of choosing an exchange rate regime, should be regarded as the central intellectual question of international monetary economics. We have formulated this question well enough to agree that it is a matter of trading off macroeconomic flexibility against microeconomic efficiency. Unfortunately, we are not completely happy with the way we model the macroeconomic side, and we have no way at all at present to model the microeconomics.” Krugman (1995) [30]

While forming a monetary union with another country is likely to enhance economic integration between the two countries, there are costs and benefits from such a decision. The relative sizes of these costs and benefits have been explored in the optimal currency literature. This literature began in the 1960s, and has had a second flowering in the 1990s. While there have been some new theoretical insights, unfortunately these have been limited and still have not tackled the most important question, namely the microeconomic benefits of joining a different currency zone. These questions remain tied up in issues of transactions costs and bounded rationality, which economists have found difficult to tackle in a convincing manner. Nonetheless, any decision to adopt a monetary union in order to promote economic integration, as the Europeans have taken, must address the monetary policy issue of substituting a permanently fixed exchange rate for a flexible one.

New Zealand officials have spent relatively little time grappling with this “central intellectual question” since the New Zealand dollar was floated in 1985. There was a brief flourish of articles examining the desirability of New Zealand forming a currency link with Australia in the early 1990s (Lloyd 1990; Vandersyp 1990; Wheeler 1990, Grimmond 1991), but none of the authors saw much benefit from abandoning the current flexible exchange rate arrangements and interest in the subject waned.

(a) The Traditional Literature

The optimal currency literature had its first flush in the 1960s (Mundell (1961), MacKinnon (1963)). The basic framework of the literature has changed little since then, and the key question can be posed as follows:

What are the key economic factors that would lead a geographic region to issue its own currency rather than adopt the currency and monetary policy of another region?

It is widely acknowledged that the optimal size of a currency area depends on the trade-off of microeconomic efficiency against macroeconomic flexibility. The efficiency costs of a region issuing its own currency include the increase in transactions costs associated with a greater number of foreign exchange transactions and an increase in price uncertainty associated with the use of a separate unit of account. To the extent that these transactions costs and price uncertainties reduce trade, there will be fewer gains from economic specialisation. The macroeconomic flexibility gains of a separate currency are twofold. First, monetary independence allows the region to choose its own inflation rate. Secondly, monetary independence enables a region to stabilise output in the face of regionally specific economic shocks by revaluing its currency and altering relative wages and prices.

In practice, the question has not been answered on geographical grounds at all as until recently most nations have had their own currencies. This has meant that most people in the world have lived in a large currency zone, as most people live in large countries. Being a small country, New Zealand is both usual as a country in having its own currency, and unusual as a geographical region which is not part of a larger currency zone. This would suggest that New Zealand is unlikely to be an optimal currency zone unless country specific factors dominate geographic factors. It is worth noting that many other small countries have responded to this tension by fixing their currency to a larger currency, either to the U.S. dollar (Hong Kong and Saudi Arabia) or to the mark (Austria, the Netherlands, Belgium and Denmark, and less tightly, Ireland, Finland, and Portugal.)[31] A flexible exchange rate is not a dominant choice for small economies.

(i) Benefits of Monetary Independence

The first main benefit of a country maintaining its monetary independence is the ability to choose its own inflation rate. Although this was important in the past, it is probably of secondary importance now, as most countries have low inflation due to improvements in central bank technology. It may be important if a country has an extreme aversion to price increases, and is unwilling to accept the inflation rate implicit in adopting a different currency. It is to be noted that low productivity countries entering a monetary union with a high productivity country will experience higher inflation rates as their productivity levels converge, as has happened in Hong Kong and Ireland recently (Balassa 1964).[32]

Secondly, monetary independence potentially enables a region to stabilise output in the face of regionally specific economic shocks by revaluing its currency and altering relative wages and prices. The benefit of a currency revaluation depends on prices and wages being sticky, for if prices are sticky a negative demand shock to exports will result in a reduction of output and employment in the rest of the economy. Under these circumstances, a currency depreciation will engineer a decline in local wages relative to the foreign wages, increasing price competitiveness and reducing the output effects of the economic shock. For this reason, currency flexibility is potentially useful in three categories of situations:

1. where shocks are regionally specific;
2. where alternative mechanisms for adjusting to shocks are weak; and
3. where exchange rate changes are effective as a means of alleviating idiosyncratic shocks.

Most of the traditional debate about currency zones has tended to be fractured along these lines. It is worth elaborating some of the issues that have arisen. In the first category, the major issue has concerned the extent to which a regional economy has a narrow industrial structure, and the extent to which shocks are sector specific. This issue has been surprisingly contentious, for although increased economic integration tends to lead to increased localised specialisation, this does not necessarily mean that shocks become more regionally idiosyncratic. For example, a region which used to make tyres and engines but which now just makes tyres is still equally exposed to the vehicle market.

The second category has been the prime focus of the debate. The extent to which an economic shock will affect income and output in a fixed exchange rate regime depends on wage and price flexibility, factor mobility (particularly labour mobility) across sectors and regions, and the degree to which there is income smoothing from private capital markets and from government transfers. Clearly these mechanisms work in quite different ways. The first mechanism induces compensating output changes through changes in relative prices, while the second induces compensating output changes through inward or outward migration of people or firms. The third mechanism does not ameliorate the employment and output effects on the affected sector, but by providing alternative sources of income mitigates the extent to which income shocks flow through to other sectors. If these mechanisms do not work effectively, the case for using exchange rate movements to stabilise output increases, assuming output stabilisation is a goal of the government or the central bank.

The final category is also important because under some circumstances an exchange rate will not be an effective means of adjusting to shocks. For a depreciation to work, workers in unaffected sectors must suffer money illusion or be willing to take real wage reductions; this is less likely the more open an economy is, for then a given depreciation will be converted to a greater cut in real wages. More generally, the effectiveness of an exchange rate change in alleviating an economic shock will depend on the industrial structure of the economy, and whether the shocks are industry specific or regional. If countries receive a similar shock, for instance, a collective exchange rate depreciation is not possible.

(ii) The Benefits of Monetary Union

The major benefits of a monetary union are the decrease in transactions costs associated with a fewer number of foreign exchange transactions and a decrease in price uncertainty associated with the use of a more widely used unit of account. As discussed in Section 2, the value of the latter benefit in both goods markets and financial markets has proved very difficult to pin down empirically; in essence it is the value of providing unlimited foreign exchange hedging across all maturities free of charge.

(b) The European Assessment

Obviously, most European countries have decided that the benefits of a monetary union outweigh the costs. It may have been the case that economic arguments were not the deciding factor in Europe’s decision to adopt a single currency, for the political drive for unification has been very strong: memories of the depressions and wars of the first half of this century have been a vital factor in the drive for political, economic, and social union. For these reasons, European decision makers may have placed a much greater weight on the benefits of integration that stem from monetary union than they did on any associated costs. Nonetheless, while their decision may not be completely relevant to other countries, many aspects of the decision are of interest.

First, the separate countries were comfortable with a pan-European inflation target, and with the monetary institutions set up to ensure the target is met (the European Central Banking System)[33]. While it is acknowledged that individual countries may have rates of price change different from the European average, this is not seen as a problem.

A second anticipated benefit from the adoption of the euro was the perceived cost reduction stemming from the elimination of currency transactions costs, and the additional indirect benefits associated with the elimination of exchange rate comparisons and exchange rate uncertainty. The direct costs were estimated to be 0.4 percent of GDP per year; in addition, it was estimated that the European economy would grow by an additional 7 percent over ten years as a result of increased competition resulting from enhanced economic integration and more transparent pricing behaviour across Europe.

Thirdly, most European countries discounted the costs of losing exchange rate flexibility, arguing that the potential for stabilisation is offset in practice by destabilising movements in the exchange rate. This argument was forcefully put in Emerson et al (1992), and has several components. First, it was argued that exchange rate flexibility within Europe is only useful if shocks are regionally specific, and that exchange rate flexibility in the face of European wide shocks is likely to lead to “beggar thy neighbour” depreciation attempts. Secondly, it was argued that economic integration will make regionally specific shocks less likely, because increased specialisation through product differentiation will make sectoral shocks less regionally specific rather than more regionally specific.[34] Thirdly, it is argued that other adjustment means, particularly wage and price flexibility, will become more important as firms respond to new competitive pressures. In addition, greater capital mobility will enable the easy financing of temporary external imbalances. Fourthly, there is considerable scepticism that monetary independence stabilises economies, for while flexible exchange rates enable countries to adjust to shocks, they are also seen as a cause of shocks in themselves. Finally, it was observed that since in practice most European countries had already given up exchange rate flexibility within the European Monetary System, there was little additional cost to forming a full monetary union.[35]