(c) Unsolved Issues in the Literature

The literature is still rather informal by modern economics standards. There are two major reasons for this:

1. the literature revolves around monetary issues concerning transactions costs and bounded rationality which are poorly understood even within a single economy setting; and
2. the advantages and disadvantages of flexible exchange rates are very difficult to model. Under many circumstances, exchange rate flexibility is precisely the appropriate response to an underlying economic shock. Under other circumstances, excessive exchange rate volatility is the cause of economic problems. It is difficult to model the process by which exchange rates and other prices may be excessively volatile as explanations rely on a mixture of bounded rationality and costly information gathering and processing.

These difficulties of the literature should not be underestimated. Monetary economics does not fit well into a neo-classical economic framework precisely because it is about economic frictions and the institutions used to overcome them. For instance, a medium of exchange is used to minimise transactions costs (including the cost of determining someone else’s credit worthiness), and a unit of account is used to minimise the difficulties of comparing relative prices due to limited rationality. Because the economics of these issues are not well understood within a traditional framework - a closed economy with a government issued fiat currency - it is difficult to model their importance within a wider framework that tries to analyse the costs and benefits of having different currencies in different regions. Consequently, it is very difficult to specify the integration benefits of enlarging a currency zone, because there is little formal understanding of why money is so useful. Adopting another currency has a cost (the increased difficulty of adjusting relative prices) and a benefit (the decreased uncertainty of the value of the national currency), both of which depend on the unit of account role of money and thus which involve bounded rationality. Without better ways to model these phenomena, economists have struggled to estimate the costs and benefits of a monetary union (Krugman, 1992).

These modelling difficulties have tended to bias the debate, for while the literature has a relatively good idea of the costs of currency union, it has little idea of the benefits of a currency union, which concern the specialisation benefits from greater monetary integration. In addition, it is much easier to point out how an exchange rate may help adjustment to an exogenous real shock than it is to argue that seemingly random exchange rate movements are a cause of economic shocks. These characteristics of the problem have meant that most of the literature has focussed on the costs of monetary union rather than the benefits of monetary union. Nonetheless, in the last decade there have been several developments that have undermined the traditional arguments that flexible exchange rates help stabilise the economy. Two of the most important of these arguments are outlined below.