However, each time monetary authorities try to reduce unemployment by increasing inflation along the short-run Phillips curve, they will end up with higher inflation in the future at the same rate of unemployment. However, if the same economies combine together and form a currency union, then the resulting economy will be more diversified with pegged exchange rate. Which regime is preferable under a given type of friction? One market, one money: The origins of the theory of optimum currency areas. While the traditional contributions towards the OCA theory were based on tenuous assumptions with partial equilibrium based static models that ended up with limited real-world applicability of the results derived, the new approach deals with modern theoretical contributions in the context of general equilibrium models and is based on microeconomic founda- tions.
Exchange rate regimes in an increasingly integrated world economy Vol. Journal of Common Market Studies, 42 4 , — Enter the email address you signed up with and we’ll email you a reset link. The Case of Russia, the Ukraine and Kazachstan. Buiter presents a thorough analytical discussion of the theo- retical issues of forming currency areas by using a seven-equation semi- small open economy model with perfect capital mobility. The fifth section presents recent work that has contributed to revival of interest in the subject.
As discussed above, the theory of OCA proposes that using a com- mon currency creates benefits as well as costs for the member countries. Third, if two countries with flexible nominal exchange rates, and hence independent monetary policies, face distur- bances in such a way that the policies responding to such disturbances depress economic activity in one region in both countries and at the same time stimulate economic activity in the other region in both countries, there exists an argument for forming two currency areas, one consisting of the depressed regions of the two countries and the other consisting of the stimulated regions of both the countries Kawai, East, in both countries, produces timber, while West makes cars.
Privredna kretanja i ekonomska politika [Internet]. First, a situation in which there are two countries, say country A and country B, and country B is negatively affected by an asymmetric demand shock. In such a monetary union, with a regional central bank assigned the objective of price stability, the less developed economy face the following situations: Also, with limited capital mobility, the early contributors to the OCA literature dealt with two extreme regimes of exchange rates: Also, a large number of small currency areas could result in thin foreign exchange markets, thereby making it easier for speculators to affect the market prices exchange rates of the currencies, and thus, hinder the conduct of monetary policy Mundell, Moreover, the efforts of the researchers to reconcile the frictions existing in earlier contributions towards currsncy OCA theory also helped the theory to re-emerge as a relevant tool of the analysis.
However, such economies might also possess a low degree of labour mobility with adjoining ckrrency, implying the desirability of flexible exchange rates. In Milton Friedman Ed.
It is in the interest ttheory Downloaded from rmi. The Economic Journal, 81— Also, the more open an economy, the smaller it is likely durrency be in terms of aggregate GDP McKinnon, All in all, the OCA theory helped to bring together sev- eral strands of the literature on monetary integration.
The OCA theory determines the conditions which countries need to satisfy in order to make the monetary union more attractive, that is, to ensure that the benefits of the monetary union exceed its costs.
The theory of optimum currency areas : a literature review
The international monetary system: Mundell and Alexander L. Even though many additional criteria are introduced in litrature modern phase, traditioal contributions are still relevant.
To peg or not to peg? Exchange rate regimes in Latin America and the Caribbean.
The theory of optimum currency areas : a literature review – EconBiz
Regions are areas within which there is factor mobility, but between which there is factor immobility Mundell,p. If the central bank increases money supply in the country as a whole, inflationary pressure in A will aggravate and the negative terms of trade for B will correct the employment problem in B.
O three basic conclusions which they derive are worth mentioning. On becoming more flexible: Thus, Downloaded from rmi.
The Theory of Optimum Currency Areas: A Literature Review
Chicago 17th Edition Cuurrency, Tanja. Canada-US regional trade patterns. Hence, just like centralised union mar- kets, these markets may also not have an incentive to ask for excessive wage increases. Labour Market Frictions In determining whether to enter a common currency area, several more issues are important to consider.
The above factors suggest that the degree of real convergence should be an important characteristic underpinning the choice of exchange rate regime.
Salant EdsEuropean monetary unification and its meaning for the United States pp.
Even though many additional criteria have been introduced in this modern phase, traditional contributions are still relevant. Economic agents in both countries would buy lesser products produced by the West and more products produced by the East, Downloaded from rmi. This leads to an inflationary pressure in A and creates unemployment Downloaded from rmi.
McKinnon also argues that changes in the nominal exchange rates in a relatively more open economy are less efficient in changing the terms of trade and less useful as an adjustment mechanism, because such changes would lead to fast and large offsetting changes in domestic wages and prices. Helpman concludes that the method for choosing among different exchange rate regimes depends on the given rigidities and imperfections.