lectures in macroeconomics- charles w. upton optimal currency areas
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Lectures in Macroeconomics- Charles W. Upton
Optimal Currency Areas
)1(2
1 22
KRK
KR
t
K
t rmmE
Optimal Currency Area 2
The Euro
• The Euro is an example of a currency union.
• The nations abandoned independent monetary authority to get a common currency.
Optimal Currency Area 3
The Euro
• The Euro is an example of a currency union.
• The nations abandoned independent monetary authority to get a common currency.
• But how big? How many nations should join?
Optimal Currency Area 4
The Problem
• Suppose the city of Kent had its own currency (Kent $, or $K) and its own monetary authority.
• The exchange rate against other currencies (such as Ravenna dollars, $R, floats)
Optimal Currency Area 5
The Proposal
• Should the cities of Kent and Ravenna merge their currencies and create a common currency, $KR?
Optimal Currency Area 6
The Proposal
• Should the cities of Kent and Ravenna merge their currencies and create a common currency, $KR?
• If they do, there will be a single monetary authority which will determine the optimal monetary policy for the Kent-Ravenna economy.
Optimal Currency Area 7
Advantages
• A single currency will mean lower transactions costs in so many ways.
• Persons in Ravenna can trade in Kent without having to worry about exchange fluctuations and without having to exchange $R for $K
– And vice versa.
Optimal Currency Area 8
Advantages
• Investors in the Kent-Ravenna can invest with reduced worries about exchange rate fluctuations.
• Or alternatively: projects in Kent and Ravenna can attract out of area investment without having to guarantee investors against exchange rate fluctuations.
Optimal Currency Area 9
Disadvantages
• Right now the Kent monetary authority sets the rate of monetary expansion mK at mK
t, the optimal rate for Kent.
• Ditto, in Ravenna where mR = mRt.
• A single monetary authority will set
)(2
1 R
t
K
t
KR
t mmm
Optimal Currency Area 10
The Loss
)(2
1 R
t
K
t
KR
t mmm
Optimal Currency Area 11
The Loss
)(2
1
)(2
1
R
t
K
t
KR
t
K
t
R
t
K
t
KR
t
mmmm
mmm
Optimal Currency Area 12
The Loss
22)(
4
1
)(2
1
)(2
1
R
t
K
t
KR
t
K
t
R
t
K
t
KR
t
K
t
R
t
K
t
KR
t
mmmm
mmmm
mmm
Optimal Currency Area 13
Some Analysis
• The optimal monetary policy at time t is
K
t
KK
t mm *
Optimal Currency Area 14
Some Analysis
),0(~ 2
*
K
K
K
t
KK
t
N
mm
t
Optimal Currency Area 15
Some Analysis
• The optimal monetary policy at time t is
R
t
RR
t mm *
Optimal Currency Area 16
Some Analysis
),0(~ 2
*
R
R
R
t
RR
t
N
mm
t
Optimal Currency Area 17
The Loss
2
**
2
)(4
1RtKt
RK
KR
t
K
t
mm
mm
Optimal Currency Area 18
The Loss
2
**
2
)(4
1RtKt
RK
KR
t
K
t
mm
mm
Assume σ2
K = σ2R
Assume mK* = mR
*
Optimal Currency Area 19
The Loss
)1(2
1
)),cov(2(4
1
2
22
2
KRK
RtKtRK
KR
t
K
t
r
mmE
Optimal Currency Area 20
The Loss
)1(2
1
)),cov(2(4
1
2
22
2
KRK
RtKtRK
KR
t
K
t
r
mmE
rKR = 1, no cost from merging
Optimal Currency Area 21
The Loss
)1(2
1
)),cov(2(4
1
2
22
2
KRK
RtKtRK
KR
t
K
t
r
mmE
rKR = 0, a cost from merging
Optimal Currency Area 22
The Theorem
• There are gains in lower transactions costs.
• But, if the two economies are independent, there will be a loss from having a monetary authority that is focused on the local area.– The magnitude of the loss depends on the
degree of independence
Optimal Currency Area 23
The Tradeoff
N
N*
Optimal Currency Area 24
West Backwater
• West Backwater wants to join either the US dollar or the Euro.
• Gains in transactions costs but what about deviations from monetary policy?
• WB citizens do not vote in American elections and will get no say in FOMC.
Optimal Currency Area 25
West Backwater
• Do they do more trading with EMU or with US?– If US, use dollar.– If EMU use Euro.
Optimal Currency Area 26
The United Kingdom
• The UK does more trading with the EMU than with the US.
• Thus if they want to join, they should EMU but not use US $.
• Unlike West Backwater, they can get a seat on the board of the European Central Bank.
Optimal Currency Area 27
Canada
• If they want to join, they should use US $.
• But it seems unlikely that we would give Canada a seat on the FOMC.
• And they may be large enough that there are no gains in transactions costs.
Optimal Currency Area 28
Ecuador
• No hope of a seat on FOMC.
• But no one had confidence in domestic monetary policy.
Optimal Currency Area 29
End
©2005 Charles W. Upton. All rights reserved