«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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I am delighted to have this opportunity to comment on the paper by Hiroshi Fujiki and Akira Otani. It is always a difficult task to write an overview paper, particularly so on a broad and highly controversial topic such as the choice of exchange rate regime. However, it is a task the authors handle very well. They cover a wide range of topics—from what lesson we can draw from the process of European monetary unification, the issues that arise in the context of the widely expected enlargement of the European Monetary Union (EMU), the costs and benefits of dollarization, to the prospects for currency unification in Asia and in the Americas, and so on—and do so in a balanced way. Overall, there is little I take issue with.
As with any broad and careful paper, this is not one that it is easy to comment on.
However, the authors would like to draw our attention to an underlying issue concerning the choice of theoretical framework in which to analyze the choice of exchange rate regime. While historically that analysis has been conducted within the framework of the Mundell-Fleming model, the paper suggests that this is not a good starting point. Rather, as they make clear in their appendix, their preference is to start from the recent literature on the “new open-economy macroeconomics,” which was initiated by Obstfeld and Rogoff (1995) and which is nicely summarized by Lane (2001). In my discussion, I will therefore focus on what that literature has to say about the central issue policymakers face, that is, whether and under what circumstances they should adopt a fixed or a floating exchange rate regime.
Before doing so, it is useful to briefly outline the most important features of the new literature. Its defining characteristic is the incorporation of Keynesian features in a dynamic general equilibrium model of the open economy. Two aspects of the models are particularly important. First, there is imperfect competition in goods markets and prices are sticky. This implies that there is a serious price-setting decision to be modeled. Moreover, with prices above marginal costs, firms would like to expand production at the current level of prices. Thus, output is in this sense demand determined. Finally, activity is below the level that would arise if goods markets were competitive. This implies that monetary policy could potentially raise welfare by expanding output. Second, firms maximize profits and consumers maximize utility. That is important because it provides a natural metric, the level of utility, which can be used to compare and rank exchange rate regimes.
It deserves to be noted that, as is the case with all economic theory, the conclusions we draw depend on the assumptions made. One particularly important assumption concerns the nature of the price-setting process. In contrast to utility functions that
57. I am grateful to Mick Devereux for useful discussion regarding the literature on the new open-economy macroeconomics. The views expressed here are solely my own and not necessarily those of the HKMA and the HKIMR.