Presentation on theme: "A model of an optimum Currency Area Lucas Antonio Ricci Research Department, International Monetary Fund (2008)"— Presentation transcript:
A model of an optimum Currency Area Lucas Antonio Ricci Research Department, International Monetary Fund (2008)
Aim of this article Develops a model of the circomstances under which it is beneficial to participate in a currency area (CA in the following). CA : fixed exchange rate (ER) regime or single currency within an area, flexible ER with RoW. Mundell (61) : OCA if cost of relinquishing ER as an instrument of adjustment are outweighed by benefits of adopting single currency.
Interest of this paper The model attempts to capture most of the cost-benefit analysis in a monetary model of trade with nominal rigidities. simultaneous analysis of both the real and monetary aspects of the optimum currency area literature.
What we do today 1.Theoretical costs/benefits of adopting a single currency 2.Description of the model 3.Shocks and adjustment under different exchange rate regimes (flexible ER vs. CU) 4.Cost/benefit analysis of a CU
1) Theoretical costs/benefits of adopting a CU. 1.Cost of adopting a CU Abandoning ER has a cost iff ER between 2 areas is an effective instrument of short run adjustment. Thas is to say : -2 areas face asymmetric shock ; -Domestic prices not fully flexible ; -Pass-through is not large ; -Adjustment through ER less costly than other instrument.
1) Theoretical costs/benefits of adopting a CU. 2. Benefits of adopting single currency (Mundell, 61) : Elimination of transaction costs Better performance of money as medium of exchange and as unit account : -Elimination of relative price distorsions ; -Elimination of ER uncertainty.
1) Theoretical costs/benefits of adopting a CU. 2. Benefits of adopting single currency (next) Important criterion : similarity of pre-union inflation rates (Fleming, 71). - countries may have different Phillips curve. - Inflation as a tax instrument (Canzoneri & Rogers) - « the advantage of tying ones hands » BUT : some could loose
2) The Model 2.1) Structure and agents behavior 2.1.1) Uncertainty, rigidities and timing of actions Uncertainty arises from demand and monetary shocks Wages are rigid Extreme version of Phillips curve in price and employment: flat at the marginal cost pricing below full employment, vertical once reached (labor supply is infinitely elastic at given wage until full employment is reached, taking wages as given, firms choose competitively optimal employment and prices).
2) The Model 2.1.2) Technology and specialization Each country produces one traded good (A at home, B abroad) and a non traded good (N, N*) Supplies of goods:
2) The Model 2.1.3) Preferences Individuals gave Cobb-Douglas preferences over money, traded goods and non traded goods For home : s.t. with tau Samuelson iceberg-type transaction cost.
2) The Model 2.1.4) Shocks and monetary rule Possible inflationary bias of the monetary authorities introduced through exogenous and anticipated ( ) increase in national money stocks With redistribution of money across countries that equilibrates money market.
2) The Model 2.2.1) Consumers behavior Maximizing the consumers problem and aggregating (for home): And for money,
2) The Model 2.2.2) Firms behavior Domestic and foreign firms maximize their profit s.t. (for home) : For domestic country, either Or :
2) The Model 2.2.3) Markets equilibrium Goods market: Money market:
2) The Model 2.2.3) Markets equilibrium (next) When goods and money markets are in equilibrium, trade balance = 0 In flexible ER, determines the level of ER : In a CU (e=1), determines the distribution of the world money stock, accross the countries, consistent with equilibrium :
2) The Model 2.2.4) Initial equilibrium From market equilibrium, we get : From zero profit condition:
3) Shocks and adjustment 3. Shocks and ajustment 3.1) Flexible ER Money stocks would change only because of the monetary increase due to inflationary bias. ER flexibility neutralizes prefectly any effect on nominal income of foreign monetary shocks and demand shocks to tradable.
3) Shocks and adjustment 3.2) Currency Union e=1 and tau=1 Money supply changes not only because of inflationary bias, but also because of redistribution
3) Shocks and adjustment 3.3) Labor mobility as a form of adjustment The migration flow that would fully adjust the demand shocks is If partial labor mobility,
3) Shocks and adjustment 3.4) Fiscal federalism tdY = - tdY* with : change in income due to real shocks that is absorbed by tax scheme Where n = 1 – epsilon - q
3) Shocks and adjustment 3.5) Expected inflation and unemployment in the two ER regimes Under flexible ER, Under CU,
4) Cost-benefit analysis of a currency union Loss function : The 2 countries constitute an OCA if both expect positive gains from CU
4) Cost-benefit analysis of a currency union 4.1) Adjustment cost component We focus on the NB resulting from the adjustment cost in terms of inflation and unemployment.
4) Cost-benefit analysis of a currency union 4.1.1) Monetary shocks If real shocks are absent or fully adjusted, the adjustment cost component due to the monetary shocks is
4) Cost-benefit analysis of a currency union 4.1.2) Real shocks If one neglects monetary shocks, the adjustment cost component due to the real shocks is
4) Cost-benefit analysis of a currency union 4.1.3) Correlation between monetary and real shocks A positive correlation between monetary shocks and demand shocks to domestic tradables reduces variability of x, decreases adjustment cost of a CU : increases net benefits for home. A negative correlation increases the net benefit for the home country Different levels of correlation between monetary and real shocks are associated with different advantages for either one country or the other.
4) Cost-benefit analysis of a currency union 4.2) The inflationary bias component « the advantage of tying ones hands » 4.3) Transaction costs Increases with openess
4) Cost-benefit analysis of a currency union 4.4) Openess Effect unclear