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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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The welfare-based approach requires us to examine not only changes in variance of macroeconomic variables but also changes in their expected level. The latter effect is ignored in the traditional Mundell-Fleming approach. Second, regardless of firms’ price-setting behavior, when domestic central banks do not have sufficient credibility, a fixed exchange rate regime would be desirable as a way to eliminate home idiosyncratic shocks.52 However, if the credibility of the home central bank is not so low, there might be some cases where a floating exchange rate regime would be better.

Third, the choice of optimal exchange rate regime between advanced economies depends on firms’ price-setting behavior and the nature of the shocks (monetary shock or productivity shock). To the best of our knowledge, little research using the Appendix Table 1 Optimal Exchange Rate Regime Based on New Open-Economy Macroeconomics

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51. This regime considers a case where both home and foreign economies fix not only the exchange rate but also an exchange rate weighted average of world money supply.

52. Shioji (2001) builds a three-country model of Japan, the United States, and East Asian economies, extending Corsetti et al. (2000), and examines the choice of optimal exchange rate regime in East Asia. He shows that switching from a fixed exchange rate regime to a floating regime or basket regime, which makes it possible to allow a depreciation of the domestic currency, is theoretically beneficial when the yen depreciates as a result of an increase in money supply or a negative productivity shock in Japan. However, he also concludes that the theoretical model which induces the above result is not supported empirically.

73 framework of new open-economy macroeconomics shows that a fixed exchange rate regime is desirable. Much research demonstrates that a floating regime is better.

C. Reservations We conclude this appendix by pointing out some reservations about these recent intensive analyses.

First, recent researches focusing on firms’ price-setting behavior can be divided into the symmetric PCP approach and the symmetric LCP approach, in the sense that there is a globally unique price-setting strategy. Therefore, under PCP, purchasing power parity (PPP) holds both in the short run and in the long run, and the exchange rate pass-through is always 100 percent. On the other hand, under LCP, the exchange rate pass-through is zero and the depreciation of the home currency leads to an improvement in terms of trade in the home economy (Obstfeld and Rogoff [2000]). However, empirical studies (such as Marston [1990] or Knetter [1993]) indicate that exchange rate pass-through lies in the range of zero to 100 percent, and that a depreciation of the home currency causes a deterioration in domestic terms of trade. To resolve this problem, a mixed PCP/LCP approach holds promise. This approach assumes that some firms set their export prices in producers’ currency and that others set theirs in local currency in an open economy, and that the ratio of PCP/LCP is asymmetric. For example, the ECU Institute (1995), cited in Obstfeld and Rogoff (2000), shows that the percentages of exports and imports which are denominated in the home currency in developed economies are relatively low, except in the United States.53 Such evidence may justify the usefulness of a mixed PCP/LCP approach (see Otani [2002] for an example).54 Second, to the best of our knowledge, studies based on the O-R model assume that the choice of currency in which prices are set is exogenous. However, the exporter’s choice of currency may well be endogenous. Devereux and Engel (2001) analyze this point using the framework of new open-economy macroeconomics.

They show that exporters generally set prices in the currency of the economy with the most credible monetary policy. Thus, the interaction between price-setting behavior and monetary policy might be a promising topic for future research.

Finally, the O-R model has its own limitations. Many central banks consider that the omission of political and strategic factors would in practice complicate the choice of currency regime and the credibility of monetary policy rules. And some might argue that the assumption of perfect capital markets55 and the omission of the accumulation of physical capital56 are appropriate for only a few economies.

53. As for the United States, 92 percent of exports and 80 percent of imports are denominated in dollars. For Japan, the percentage of exports and imports, respectively, denominated in the home currency are 40 percent and 17 percent. For Germany, the respective totals are 77 percent and 56 percent (Obstfeld and Rogoff [2000, p. 123]).

54. Otani (2002) explicitly incorporates asymmetric price-setting behavior into Betts and Devereux (2000) and shows that the international transmission effect of monetary policy is not symmetric, depending on the difference of price-setting behavior between the home economy and the foreign economy.

55. For example, Devereux (2001) assumes that economies cannot access international financial markets and concludes that a fixed exchange rate regime is superior to a floating exchange rate regime based on the maximum attainable welfare level. However, in practice, emerging market economies can access international financial markets subject to the “original sin hypothesis” (Eichengreen and Hausmann [1999]). Therefore, research on the optimal currency regime under incomplete international financial markets would be desirable.

56. Recently, a number of researchers have tried to incorporate capital accumulation into “new open-economy macroeconomics.” For example, see Kollmann (2001) and Chari et al. (2000).

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Alesina, Alberto, and Robert J. Barro, “Currency Unions,” Quarterly Journal of Economics, 117, 2002, pp. 409–436.

Aliber, Robert Z., “Introduction,” in Robert Z. Aliber, ed. International Finance, Volume 1, The International Library of Critical Writings in Economics, An Elgar Reference Collection, 2000.

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Baliño, Tomás J. T., Adam Bennett, and Eduard Borensztein, “Monetary Policy in Dollarized Economies,” IMF Occasional Paper 171, International Monetary Fund, 1999.

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Bordo, Michael D., and Lars Jonung, “The Future of EMU: What Does the History of Monetary Unions Tell Us?” NBER Working Paper No. 7365, National Bureau of Economic Research, 1999.

———, and Harold James, “The Adam Klug Memorial Lecture: Haberler versus Nurkse: The Case for Floating Exchange Rates as an Alternative to Bretton Woods?” NBER Working Paper No.

8545, National Bureau of Economic Research, 2001.

Braga de Macedo, Jorge A., Daniel Cohen, and Helmut Reisen, eds. Don’t Fix, Don’t Float, OECD Development Centre Studies, Organisation for Economic Co-operation and Development, 2001.

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Calvo, Guillermo A., “Capital Markets and the Exchange Rate: With Special Reference to the Dollarization Debate in Latin America,” mimeo, 2000.

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Chang, Roberto, and Andres Velasco, “Financial Fragility and the Exchange Rate Regime,” Journal of Economic Theory, 92, 2000, pp. 1–34.

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Chari, V. V., Patrick, J. Kohoe, and Ellen R. McGrattan, “Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?” Staff Report 277, Federal Reserve Bank of Minneapolis, 2000.

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75 Cooper, Richard N., “Exchange Rate Choices,” mimeo, 1999.

Corbo, Vittorio, “Is It Time for a Common Currency for the Americas?” Journal of Policy Modeling, 23, 2001, pp. 241–248.

Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini, “What Caused the Asian Currency and Financial Crisis?” Japan and the World Economy, 11, 1999a, pp. 305–373.

———, ———, and ———, “Paper Tigers? A Model of the Asian Crisis,” European Economic Review, 43, 1999b, pp. 1211–1236.

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Dellas, Harris, and George S. Tavlas, “Lessons of the Euro for Dollarization: Analytical and Political Economy Perspectives,” Journal of Policy Modeling, 23, 2001, pp. 333–345.

Devereux, Michael B., “International Risk-Sharing and the Exchange Rate: Re-Evaluating the Case for Flexible Exchange Rates,” CEPR Discussion Paper No. 2900, Centre for Economic Policy Research, 2001.

———, and Charles Engel, “Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime,” NBER Working Paper No. 6867, National Bureau of Economic Research, 1998.

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Edwards, Sebastian, “Dollarization Myths and Realities,” Journal of Policy Modeling, 23, 2001a, pp. 249–265.

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———, and Ricardo Hausmann, “Exchange Rates and Financial Fragility,” in New Challenges for Monetary Policy, a symposium sponsored by the Federal Reserve Bank of Kansas City, 1999.

Engel, Charles, “Optimal Exchange Rate Policy: The Influence of Price Setting and Asset Markets,” Journal of Money, Credit and Banking, 22 (2), 2001, pp. 518–541.

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———, “Lessons from Argentina,” mimeo, 2002 (http://www.nber.org/~confer/2002/argentina02/ feldstein.pdf).

Fischer, Stanley, “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic Perspectives, 15 (2), 2001, pp. 3–24.

Folkerts-Landau, David, and Peter M. Garber, “The ECB: A Bank or a Monetary Policy Rule?” in Matthew B. Canzonerik, Vittorio Grilli, and Paul R. Masson, eds. Establishing a Central Bank: Issues in Europe and Lessons from the US, Cambridge: Cambridge University Press, 1992, pp. 86–110.

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76 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview ———, and Andrew K. Rose, “The Endogeneity of the Optimum Currency Area Criteria,” The Economic Journal, 108, 1998, pp. 1009–1025.

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