Monetary Policy and Macroeconomic Stabilization

The Roles of Optimum Currency Areas, Sacrifice Ratios, and Labor Market Adjustment

Ole Roste

• Editorial: Routledge
• Año: 2017
• ISBN:
  9781351504874
• Edición: 1
• Categoría: Economía
• Categoría: Política monetaria

As a fundamental review and critique of activist economic policies, this book is a unique contribution to classical political economy. "Monetary Policy and Macroeconomic Stabilization" is about macroeconomic stabilization policy, with emphasis on the value of a distinct national monetary policy to growth. Ole Bjorn Roste's argument is for public officials to restrain themselves in the pursuit of policy. As the author notes: when you know less, you should do less.The history of modern macroeconomics started in 1936 with the publication of Keynes' "General Theory of Employment, Interest, and Money". The problems of the Great depression of the 1930s paved the way for a change of focus, from the long run to economic fluctuations in the short run, and from nominal to real variables, such as unemployment and aggregate output.Keynes offered clear policy implications in tune with the times. Because economic adjustment was slow, waiting for the economy to recover by itself was irresponsible. Particularly fiscal policy was essential to return to high employment. Monetary policy could affect aggregate demand through Interest rates, but was less important. Roste discusses the role of monetary policy, starting out with the implications of the theory of optimum currency areas (OCAs). This is followed by estimates of the output loss associated with disinflation policy (the sacrifice ratio) for six OECD economies. Further, Roste models the dynamic adjustment to negative, local labor-market shocks, with particular relevance to Scandinavia, in a final section.The idea that governments should pursue stabilizing fiscal or monetary policies with regard to real variables is often taken for granted by the public, if not by economists. Among the reasons for skepticism, is the presence of differing views on how economies really work, that the state of a given economy becomes known only after a time lag, and that economic agents react to policy and expectations of policy. For these reasons, the effects of policy are generally uncertain. This book explains why the role of history is critical to the study of macroeconomics.p>

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Optimum Currency Areas: Currency Area Composition and Exchange-Rate Regimes—Theory and Evidence Reconciled

1. Introduction

The current economic literature on the advisability of various compositions of currency areas dates back to the 1960s, when Mundell (1961) initiated the literature on optimum currency areas (OCAs). This literature analyses the economic efficiency and stabilization properties of variously sized currency areas.¹ Efficiency properties are believed to improve with increasing size of a currency area. The reason is that the operation of a large currency area may facilitate the exploitation of monetary scale economies and positive network externalities. Stabilization properties, however, may worsen with increasing size because large currency areas may consist of regions of different economic structure, and hence different stabilization needs.

The OCA theory aims at analyzing properties of currency areas, not at predicting the composition of currency areas. In spite of this, it may be of interest to consider actual composition of currency areas in view of the theory of OCAs. The reason is that we can expect the composition of real-world currency areas to reflect the incentives faced by the decision-makers. Failed attempts to reconcile the OCA theory with the composition of currency areas may indicate that other important incentives are at work. This essay thus aims at evaluating actual currency area outcomes in light of the OCA theory.

The recent debate on currency area composition has to a large extent been pursued in relation to the European Monetary Union (EMU). The economic literature on EMU has mainly been concerned with the economics of monetary unions—i.e. with whether EMU would constitute an OCA. Apart from the more technical aspects of transition to a monetary union, other economic consequences of EMU have been much less discussed. Since there are important political implications involved, monetary unification has also been studied by political scientists.² However, the field has been divided between the two disciplines. I suspect that in isolation, either approach could be too partial to account for decisions that are likely to reflect a mixture of different expected effects of currency area delimitation. To understand decisions such as the establishment of EMU, one should probably combine economic and political perspectives. However, there have been few such attempts, and no unifying framework of analysis has emerged. The OCA theory thus serves as the point of departure, as a quite general economic framework and the most established analytical framework in relation to currency area composition.

Monetary unification is likely to have profound economic implications, the most important of which may fit within the framework of OCA theory. However, implications related to stabilization costs of large currency areas have been emphasized more than those related to the microeconomic efficiency. Many contributions to the OCA theory have emphasized strongly the costs of a common currency, and hence a common monetary policy, in the presence of asymmetric shocks. This aspect has also been more thoroughly researched than the positive effects of enhanced efficiency. In spite of this tendency, the balance seems to have shifted, and several recent contributions to the OCA literature tend to view large currency areas more favorably. The same applies for the political science literature, which has been most concerned with the international level: Monetary cooperation has been studied in an international relations perspective, where the coordination gains from joining fixed exchange rate mechanisms have been highlighted – the classical gold standard, Bretton Woods, the Exchange Rate Mechanism (ERM) in the European Monetary System, and EMU.³ Political scientists have also been concerned with monetary cooperation as an aspect of integration between states.⁴ A further influential political-science perspective has been the study of monetary policy as embedded in domestic politics, and influenced by interest groups and sector interests. The latter approach has focused on distributional consequences of exchange rate levels (or exchange-rate regimes that may be seen as linked to the expected future developments in international value of a currency), linked to the consumption or production of traded and non-traded goods.⁵

For a long period, empirical economic studies severely lagged the OCA theory. This situation changed during the 1990s, mainly due to the debate on EMU instigated by the Delors report and its background studies (Commission of the European Communities, 1990). Since then, a number of empirical studies have attempted to operationalize the OCA theory to obtain evidence on the costs and benefits of EMU (for a survey, see Bay-oumi and Eichengreen, 1996). Prior to the launching of monetary union in 1999, numerous studies had evaluated the prospects for EMU from the perspective of the OCA theory, most often with pessimistic conclusions. The studies tended to focus quite narrowly on the stabilization costs. Thus, the costs of temporary asymmetric real shocks within a currency union were often emphasized more than the benefits of avoiding shocks to relative nominal interest rates and exchange rates (hereafter monetary shocks) and improved microeconomic efficiency. This specific focus was in part due to improved techniques, around 1990, for the measurement of historical shocks and distinguishing between various types of shocks. A rather narrow focus on less appropriate stabilization and near-neglect of microeconomic benefits was usually defensible in the context of the individual studies. However, in a larger context this emphasis may have contributed to biased conclusions in empirical research on EMU.

The stabilization-cost argument against large currency areas rests on the presumption of a stabilizing monetary policy. A necessary, but not sufficient, condition for this is nominal rigidities. Without nominal rigidities, real variables would not be affected by changes in nominal variables and there would be no role for monetary policy (see, e.g., Buiter, 2000a). Nominal stickiness has been well documented empirically. In particular, money wages in many countries have been found to be downwardly rigid. Further, Obstfeld (1998) provided evidence of monetary shocks in G7 countries, implying price stickiness, which probably extends to most industrial countries. The sources of nominal stickiness may to a large extent be fairness considerations and legal mechanisms linked to nominal contracts (see e.g., Holden, 2004).

However, the presence of nominal stickiness does not suffice for monetary policy to be stabilizing. One reason why it may not be stabilizing is that nominal stickiness may lead to transmission of shocks from the exchange rate to real variables. The central bank may be able to control the short-term interest rate, but much less able to control or strongly influence the short-term variations in a market-determined exchange rate. This could pose severe problems, particularly in small and open economies. Shocks to the relative (nominal, and, in the short term, real) exchange rate vis-à-vis other members would disappear by definition in a monetary union.⁶ This is not to say that the effects on the real economy of the common nominal exchange and interest rate in a monetary union would be identical. These real effects will clearly depend on economic structure. Although the real economy may be quite inert to short-run exchange rate variation, monetary self-management may not be more stabilizing than a fixed, non-adjustable exchange rate.

Although the OCA perspective played an important role in assessments of the economic costs ands benefits of EMU (as illustrated for instance by the Swedish Ministry of Finance’s (1997) negative advice regarding Swedish membership), the OCA literature cannot explain the eagerness of European political leaders to launch EMU, and for most European countries to want to join the union as soon as possible (Denmark, Sweden and the United Kingdom are important exceptions). The motivation for EMU was therefore increasingly seen as political. According to Willett (2000), the establishment of EMU was puzzling; “[EMU] is here at last, but according to economists’ traditional perspectives on economic policy making it shouldn’t be” (p. 379). Willett sees this as an important warning signal that policy economists need to examine their assumptions about the forces that generate economic policy decisions. See also, e.g. Feldstein (1998), who held that EMU was not advisable on economic grounds but would be implemented nonetheless for political reasons.

Geographically, most currency areas coincide with states. Decisions on the geographical delimitation of currency areas will thus be taken by national governments, in isolation or jointly. There are few examples of multinational currency areas, and EMU remains a unique example of the voluntary pooling of monetary sovereignty among nations.⁷ Small states may peg their exchange rate by adopting the currencies of larger neighbors. However, they rarely receive compensation for foregone seigniorage, and do not as a rule influence on the monetary policy of the larger neighbor whose currency is adopted.⁸

Examples of multinational currency areas are Andorra, Liechtenstein, Monaco, San Marino and the Vatican, who have surrendered monetary autonomy to adopt the euro and the Swiss franc (Liechtenstein). Luxembourg pooled monetary sovereignty with Belgium for many years prior to 1999. These two countries had maintained separate currencies which exchanged at par and were legal tender in both countries since 1921. Monetary policy was de facto under control of the Belgian monetary authorities, although formally a joint agency managed exchange regulations (Graboyes, 1990).

Iceland provides a counter-example of the tendency for small open economies to fix their exchange rates. This country maintains a separate currency in a small open economy with only 250,000 inhabitants (see, Buiter, 2000b). This choice may, however, be due to the isolated location of this literal island economy – in the middle of the Atlantic Ocean – and the significant foreign trade with both the United States and the euro zone, complicating the choice of one distinct anchor currency.

Dollarization, i.e. the introduction of a foreign currency, often the U.S. dollar, in the territories of sovereign countries, may also be seen as a manifestation of multinational currency areas. Introduction of the U.S. dollar in countries like Nigeria or Panama reflects a highly asymmetric (non-reciprocal) kind of monetary unification where monetary policy is run solely by the United States, who also captures all seigniorage. This asymmetry in influence may contribute towards explaining why dollarization has thus far been restricted to high-inflation, developing countries marked by macroeconomic instability. The examples above of multinational currency areas point to the uniqueness of the characteristics of EMU of a common monetary policy and the sharing of the seigniorage.

One reason why it is difficult to derive precise hypotheses from the OCA theory is that it is quite general, consisting of several, arguably interlinked criteria. Second, limited variation in the dependent variable over time complicates the task of investigating the economic rationale behind currency area design. The constitution and dissolution of currency areas occur rarely and disintegration of currency areas is most often linked to severe political unrest that may dwarf economic considerations in the decision-making (Goodhart, 1995; Bordo and Jonung, 2000).⁹ There are thus few observations of changed currency area composition to study, particularly from ‘normal times’. Third, in instances where the theory does not seem to fit with the evidence, it is difficult to know the implications. The reason is that the OCA theory may be dominated by other factors. Particularly within states, core national institutions, such as fiscal and monetary and payments systems may benefit strongly from the one-nation one-currency regularity.

This essay serves two purposes. First, it surveys the OCA literature,¹⁰ emphasizing in particular its ability to account for currency area composition. Second, the paper presents a crude empirical investigation of the impact of OCA criteria on exchange-rate regime choices. If concerns of both macroeconomic stability and microeconomic efficiency are important, one would also expect these concerns to be reflected in exchange rate regime choices within currency areas. Compared to floating exchange rates, fixed rates should imply better economic efficiency properties and worse stabilization properties. This may be interpreted as an indirect test of the positive OCA theory. Decisions on exchange rate regimes are usually taken within states, presumably with comparatively few political constraints. (At least for small states, the international effects should be small.) This should provide a ‘benign’ environment for a test of the theory since one would expect the economic decision criteria to carry a high weight relative to political criteria: First, exchange-rate regime decisions are more reversible than decisions of currency area composition. This should reduce the costs of errors and thus allow for more variation in the dependent variable. Second, internal decisions do not require international negotiations. This is another reason why we should expect more variation in the dependent variable in decisions within countries (on exchange-rate regimes) than for decisions affecting several countries (on currency area composition). If this interpretation is correct, our indirect test via exchange-rate regime choices will allow both for more variation in the dependent variable and for more data points than would a more direct test of currency area composition. We thus investigate whether the OCA criteria can account for exchange-rate regime choices within currency areas.

In the empirical analysis of section five we consider exchange-rate regime choices in 28 countries for the years 1978, 1988 and 1997, and include one additional country for 1988 and 1997. The exchange-rate regimes are classified as reported by national authorities to the International Monetary Fund. These are interpreted as exchange-rate regime choices (either in the same years or at some earlier point). The sample has been constrained to western industrialized countries and a few large emerging market economies. We have chosen not to include small emerging market economies, where decision processes and the concerns involved are likely to differ from those of industrialized countries. Further, for small emerging market economies, the data are less readily available and often of low quality. Our choices imply that it is not clear to what extent the findings are relevant for developing countries. Observations from several points in time are used for most countries, to exploit the time dimension of the data. It turns out that also exchange-rate regime choices within currency areas are characterized by rather limited variation in the dependent variable. Because of this, data points for the same country are separated in time by approximately one decade -striking a ba...

Índice

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Preface
• Introduction
• 1. Optimum Currency Areas: Currency Area Composition and Exchange-Rate Regimes—Theory and Evidence Reconciled
• 2. Measuring the Sacrifi ce Ratio: Some International Evidence (with Kai Leitemo)
• 3. Regional Labor Market Adjustment in Norway