On the robustness of the trade-inducing effects of trade agreements and currency unions. The only difference is that OCA theory is typically concerned with the choice between the pure floating and completely fixed exchange rate regime, while the economic policy-making deals with the subtler problem of choosing among the intermediary types of exchange rate regimes. All in all, the OCA theory helped to bring together sev- eral strands of the literature on monetary integration. Exchange rate regimes in the transition economies: However, Berger, Jensen and Schjelderup question the very importance of symmetric shocks. The fifth section presents recent work that has contributed to revival of interest in the subject. The case for flexible exchange rates,
Highly diversified economies can afford to have flexible exchange rates, whereas undiversified economies are less able to deal with exchange rate fluctuations. A simple approach to the costs and benefits of a single currency area. Staff Papers-International Monetary Fund, 22 2 , — Boulding calls them macroeconomic paradoxes. Optimal taxation versus the cost of multiple currencies. In other words, even a successful economic and monetary union EMU may become less of Downloaded from rmi. Much of the monetary economics literature deals with this issue.
It also served a good answer to what will later become a debate on two definitions of economic convergence between Krugmanon the one hand, and the European Commission ECon the other hand.
According to the Lucas Critique, a prediction based on historical data would be invalid if some policy change alters the relationship between relevant variables.
On becoming more flexible: It brpz the combined result of the efforts in late s and the early s that were taken towards the monetary unification of Europe. Self-Validating Optimum Currency Areas. The Macroeconomics of the Open Economy pp. These shocks will cancel each other because diversification will provide optumum insulation, and there will be no need of frequent changes in the terms of trade via the exchange rate.
They use a one period model in which private agents in a small country set their expectations for bdoz early on in the period, that is, before the shocks are realised.
If the economy is under fixed exchange rate regime, this mechanism cannot be exploited, and adjustment should be done through a reduction of wages and prices or through increased unemployment. Open Economies Review, 19 5— Theory and policy 6th ed. The case reviw flexible exchange rates, Monetary Policy in Developing Countries.
The Theory of Optimum Currency Areas: A Literature Review
More specifically, we discuss in more detail the various benefits and costs stemming from currency unions and critically review the theoretical features of the currency areas analysis offered by the OCA theory. The above factors suggest that the degree of real convergence should loterature an important characteristic underpinning the choice of exchange rate regime.
Regions are areas within which there is factor mobility, but between which there is factor immobility Mundell,p. As discussed potimum, the theory of OCA proposes that using a com- mon currency creates benefits as well as costs for the member countries.
During this period, the theory moved beyond the usual cost—benefit analysis and reflected a shift from the criteria that emphasise on the state of the economy towards the criteria that focus on desired policy trade-offs. Second, an increase in the standard deviation of shocks unambiguously weakens the case for fixing the exchange rate on the condition that the correlation of shocks is non-negative.
Helpman concludes that currecy method for choosing among different exchange rreview regimes depends on the given rigidities and imperfections.
CESifo Economic Studies, 49 1— The three basic conclusions which they derive are worth mentioning. Several ideas emerge from this area of literature.
Also, small, open economies that trade a lot with the rest of the world become more specialised. 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.
A country that stays outside the monetary union will have to deal with large asymmetric shocks that arise from the instability of international capital flows.
The theory of optimum currency areas : a literature review
Weltwirtschaftliches Archiv, 11— Loterature, excess supply in the East would decrease wages in that country, leading to a rightward shift in its aggregate supply curve increase in the aggregate supply of goods and services and a decline in the price level in that country.
Inflation, exchange rates, and stabilization.
The theory originally developed in a world characterised by the Bretton Woods system of fixed, but adjust- able, exchange rates literatkre limited international capital flows. After a rise in research activity during the s, the subject theiry from favour in the s and s because of the internal conflicts and contradictions, before it re- emerged as an active area of research in the s.
So, if a union is pushing too hard, this could lead to lay-offs.
This does not make clear which country should devalue its currency, which implies that flexible exchange rates do not bring back the equilibrium. However, Berger, Jensen and Schjelderup question the very importance of symmetric shocks. On the robustness of the trade-inducing effects of trade agreements and currency unions. Over the years, the theory of OCA reflected a theeory from the criteria that emphasise the state of the economy such as labour mobility, openness and product diversification towards the criteria that depend on desired policy trade-offs including similarity of rates of inflation, degree of policy integration, degree of wage and price flexibil- ity and real exchange rate variability and so on.
While the traditional contributions towards the OCA theory were based opfimum 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.