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«Do Currency Regimes Matter in the 21st Century? An Overview Hiroshi Fujiki and Akira Otani This paper selectively reviews the recent literature on ...»

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Therefore, an optimal domestic monetary policy framework would achieve both domestic stability and international stability. Obstfeld and Rogoff (2001) showed that when monetary policy is governed by a rule-based policy, the gains from international policy coordination are not necessarily very large within the framework of the “new open-economy macroeconomics” discussed in the appendix. Thus, Rogoff (2001) suggests that at least three or four currencies are preferable in the foreseeable future. Meltzer (1996) suggests the United States, Germany, and Japan should follow an adaptive monetary rule to achieve zero expected inflation. Very small economies should eliminate the monetary operations of their central banks by establishing a currency board or a permanently fixed exchange rate. Those economies should permit their citizens to use foreign currency in a low-inflation economy as a medium of exchange to enforce commitment. This proposal shows that the best policy for a small economy to follow depends on the policies followed by the major currencies. Under this proposal, all small economies gain by pegging to the currency of large economies or the basket. They import low inflation and gain from a fixed 68 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview exchange rate. Moreover, large economies gain too, since they have stable prices at home and for imports from the small economies. But they also buffer real shocks by floating their currencies, facilitating adjustment to real shocks. Are those proposals robust in the world of currency competition among a few currencies? Could currency substitution be a destabilizing factor in such an era?

Third, although this paper implicitly assumes that the major currencies will be the dollar, euro, and yen, should we take this limitation for granted in the long run?

For example, Buiter (2000b) expects that “within a decade or two, the advanced industrial countries will have 2.5 currencies among them: the Euro, the US$, and something around the Yen or the Yuan.” Those opinions pose another important question: how many central banks will survive in the long run? Alesina and Barro (2002) examine the optimal number of currencies that would balance the gains from more international trade due to the existence of a single currency and the cost of losing an independent monetary policy. Regions joining the same currency area will experience reduced trading costs. Hence, without the cost of integration, regions are better off having a single currency. However, the political costs of integration rise as the size of the economy increases, hence single currency equilibrium does not occur.

Their model shows that as the number of economies increases, the average size of the economy decreases, and the volume of international transaction expands. Hence, an increasing number of economies will find it profitable to relinquish independent currencies, possibly even faster than the number of economies. Although it is unclear whether the prediction is correct, central banks should be ready to answer these theoretical questions within a decade or so.




Obstfeld and Rogoff (1995) presented the dynamic general equilibrium model (O-R model), which incorporated price rigidities—a traditional feature of Keynesian economics—and imperfect competition. The model features at least two advantages that suggest it as a “superior alternative to the Mundell-Fleming model” (Lane [2001]).

First, the classic IS-LM approach may not be useful for the sake of future policy recommendations, since it relies on reduced-form macroeconomic models whose parameters can vary under alternative policy regimes. However, “new open-economy macroeconomics” allows a researcher to form a detailed analysis of the effect of internal and external shocks on the choice of labor, leisure, and consumption made by a representative agent and the profits of representative firms under the assumption of optimization behavior. Second, new open-economy macroeconomics summarizes such effects on the maximum level of utility for a representative agent; thus, a researcher does not need to use ad hoc welfare criteria to evaluate the effectiveness of economic policies and exchange rate regimes. In this appendix, we will review some new open-economy macroeconomics models that incorporate uncertainty and the choice of exchange rate regime.

A. Models with Uncertainty in the Spirit of the O-R Model Many researchers have recently tried to build stochastic versions of new open-economy macroeconomics models with monetary policy shocks or productivity shocks.

For example, Obstfeld and Rogoff (1998) add uncertainty concerning changes in money supply to their original O-R model. They show that the variability of money supply influences not only the variance of consumption and production but also the expected level of those two variables. The reasons are as follows. Suppose firms risk-averse to changes in profit levels face uncertainty in foreign money supply. They charge higher export prices than they would do without uncertainty, because they add a risk premium to compensate for uncertain changes in foreign monetary policy.

Higher export prices decrease the expected level of production. They also improve the terms of trade and change the expected level of consumption. Note that the traditional Mundell-Fleming approach focuses only on changes in the variance of macroeconomic variables across policy regimes. However, the O-R approach suggests that the evaluation of the choice of exchange rate regimes and alternative monetary policy rules would be better compared by means of the maximum attainable utility that reflects both the levels and variances of relevant macroeconomic variables under alternative policy regimes.

B. Choice of Exchange Rate Regime Based on the O-R Model Recent studies examine the optimal exchange rate regime taking into account three different macroeconomic environments. First, alternative price-setting behaviors of firms (producer’s currency pricing [PCP] or local currency pricing [LCP]). Second, different types of uncertainty (such as monetary shock or productivity shock). Third, whether an economy should accommodate external shocks or not (that is, whether it is insulated from the foreign shock or else imports a foreign discipline in the presence 70 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview of domestic monetary shock). We will review three recent theoretical contributions to the choice of exchange rate regime, based on new open-economy macroeconomics in turn.

1. Devereux and Engel (1998) Devereux and Engel compared fixed versus floating exchange rate regimes based on their usefulness in insulating an economy from foreign monetary shock.47 They showed that the optimal exchange rate regime depends on whether prices are set in the producer’s currency or the local (buyer’s) currency.

First, under symmetric LCP, variability in the exchange rate does not influence import prices in the home economy, thus the economy is completely insulated against external shocks. Therefore, the ranking in the variance of the relevant macroeconomic

variables satisfies the following inequality:

Floating exchange rate regime under LCP floating exchange rate regime under PCP fixed exchange rate regime.48 The latter part of inequality in this result is consistent with Friedman (1953), who assumed PCP and concluded that a floating exchange rate regime was superior to a fixed exchange rate regime.

Second, let us see the effects on the expected levels of key macroeconomic variables. Since firms add a risk premium to local currency-denominated export prices taking into account exchange rate volatility under PCP, the expected level of consumption will decrease. However, under LCP, firms do not change their local currency-denominated export prices to compensate for changes in the exchange rate, thus an external monetary shock does not influence the expected level of consumption at home. After estimating changes in overall welfare, they conclude that a floating exchange rate regime is desirable under LCP, since it can insulate the economy completely from an external monetary shock. However, they also show that a floating exchange rate regime is not always desirable under PCP, because it cannot completely prevent an external shock from affecting the home economy.

2. Engel (2001) Engel investigates the welfare effects of fixed and floating exchange rate regimes under PCP and LCP when a domestic monetary shock is not negligible, and on this basis he proposes an optimal exchange rate regime between the United States and Mexico.49 He assumes that the monetary policy in each country is independent of the other and that the money supply in each country follows a random-walk process.

According to his analysis, if foreign firms set export prices in local (home) currency (LCP), a fixed exchange rate regime is superior to a floating exchange rate regime, provided that the variance of the domestic money supply is larger than that

47. Devereux and Engel (1998) assume foreign monetary shock not as the change in the average of foreign money supply but the rise in its variance.

48. When the fixed exchange rate regime is adopted, choice of currency is irrelevant.

49. He also analyzes the asymmetric case where a domestic firm’s price-setting behavior is LCP and a foreign firm’s behavior is PCP.

71 of the foreign money supply. In other words, the credibility of domestic monetary policy is lower than that of the foreign economy. Intuitively, the home economy can eliminate domestic monetary shock through the import of a credible foreign monetary policy.

Consider the case where foreign firms set export prices in the home currency (PCP). Engel shows that a floating exchange rate regime could be desirable even if the variance of the domestic money supply is to some extent larger than that of the foreign money supply. This may be puzzling, because fixed exchange rates eliminate idiosyncratic risk. The answer to this puzzle is that, for a certain value of the variances of home and foreign money supply, floating exchange rates can reduce aggregate risk at the risk of increasing idiosyncratic risk. Intuitively, under a floating exchange rate regime, real money supply (or real consumption in his specification) is less volatile than the nominal money supply if there is any pass-through of the exchange rate price to prices. More specifically, he proves that under a floating exchange rate regime, the variance of consumption is var(c) = n 2σm2 + (1 – n )2σm*2, where σm2 is the variance of the home money supply, σm*2 is that of the foreign money supply, and n is the relative country size. On the other hand, under a fixed exchange rate regime, var(c ) =σm*2. Therefore, even if σm2 is larger than σm*2, the variance of consumption under a floating exchange rate regime could be smaller than under a fixed exchange rate regime, depending on the value of σm2, σm*2, and n.

3. Obstfeld and Rogoff (2000) Obstfeld and Rogoff construct a stochastic model with productivity shock and examine the optimal exchange rate regime under the assumption that firms set their export prices in producers’ currency (PCP).

First, they investigate “constrained-efficient” monetary policy rules, in the sense of maximizing an average of home and foreign expected utilities subject to the optimal wage-setting behavior of workers and optimal price-setting behavior of monopolistically competing firms. Then they show that, under their parameterization, if policymakers can absorb the productivity shock, by suitably adjusting home and foreign monetary policy rules, this behavior replicates an efficient resource allocation under flexible price-setting, and those rules are optimal from the viewpoint of an economy’s individual perspectives.50 This policy rule is procyclical with regard to productivity shock. For example, a positive productivity shock under conditions of flexible prices increases the wage level, labor supply, and production. Under the predetermined wage, “constrained-efficient” monetary policy requires an increase in money supply in responding to a positive productivity shock, thus the response is inherently procyclical. Since the nominal exchange rate is determined by both domestic and foreign money supply, “constrained-efficient” monetary policy allows the exchange rate to fluctuate in response to cross-country differences in productivity shocks under a floating exchange rate regime.

Second, Obstfeld and Rogoff calculate the expected utility for three alternative monetary regimes—a fixed exchange rate regime, a floating exchange rate regime,

50. The monetary policy rules discussed here cannot offset the monopoly distortions; they merely bring the economy to flexible price equilibrium with the monopoly distortions.

–  –  –

and world monetarism51—to compare the performance of mitigating the effects of uncertainty in productivity. They conclude that a floating exchange rate regime can realize the highest welfare, since exchange rate moves respond to differences in productivity shocks between the home economy and a foreign economy under the optimal monetary policy.

4. Summary We may well consider that the choice of optimal exchange rate regime with productivity shock and foreign monetary shock is relevant to the choice of exchange rate regime between developed economies if we assume that monetary disturbances in developed economies are negligible enough to ignore. On the other hand, we may also regard models with home monetary shock as approximating an optimal exchange rate regime between developed economies and emerging economies under the assumption that domestic monetary shocks in developing economies are large.

Based on those assumptions, we summarize tentative conclusions obtained from these recent studies in the Appendix Table 1. This shows, first, that the welfare-based approach is a promising way to consider the choice of optimal exchange rate regime.

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