Optimum Currency Areas New Analytical and Policy Developments Editors Mario I. Blejer, Jacob A. Frenkel, Leonardo Leiderman, and Assaf Razin, in cooperation with David M. Cheney International Monetary Fund 1 9 9 7 ©International Monetary Fund. Not for Redistribution ©1997 International Monetary Fund Cover design by Massoud Etemadi and interior design by Julio Prego IMF Graphics Section Library of Congress Cataloging-in-Publication Data Optimum currency areas: new analytical and policy developments / editors, Mario I. Blejer, Jacob A. Frenkel, Leonardo Leiderman, and Assaf Razin; in cooperation with David M. Cheney p. cm. Includes bibliographical references (p.). ISBN 1-55775-652-X (pbk.) 1. Monetary unions. 2. Monetary policy. I. Frenkel, Jacob A. II. Leiderman, Leonardo, 1951- . III. Razin, Assaf. IV. Cheney, David M. V. Title. HG3894.B58 1997 332.4'6—dc21 97-13514 CIP Price: US$15.00 recycled paper Address orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, U.S.A. Telephone: (202) 623-7430 Telefax: (202) 623-7201 E-mail: [email protected] Internet: http://www.imf.org ©International Monetary Fund. Not for Redistribution CONTENTS Preface 1 Acknowledgments 3 1. Introduction Mario I. Blejer, Leonardo Leiderman, and Assaf Razin 7 2. Contributions of Robert A. Mundell A Theory of Optimum Currency Areas (1961) 17 Updating the Agenda for Monetary Union 29 3. Policy Forum: Fixed Versus Floating Exchange Rates: What's New in the Debate? 51 William R. White Jacob A. Frenkel Richard Portes Manuel Guitian Assaf Razin 4. New Developments The Endogeneity of the Optimum Currency Area Criteria Jeffrey A. Frankel and Andrew K. Rose 67 Openness and the Cost of Fixing Exchange Rates in a Mundell- Fleming World, Daniel Gros and Alfred Steinherr 69 Exchange Market Pressure and Exchange Rate Management: Perspectives from the Theory of Optimum Currency Areas, Tamim Bayoumi and Barry Eichengreen 72 EMU: Ins, Outs, and the Macroeconomic Effects of Alternative Monetary Policy Rules, Thomas Krueger, Douglas Laxton, and Assaf Razin 76 ill ©International Monetary Fund. Not for Redistribution iv • CONTENTS The Credibility Problem, EMU, and Swedish Monetary Policy, Alex Cukierman 86 Two Concepts of Money, and the Future of Europe, C.A.E. Goodhart 89 Debt-Creating Versus Nondebt-Creating Fiscal Stabilization Policies: Ricardian Equivalence, Fiscal Stabilization, and EMU, Tamim Bayoumi and Paul R. Masson 97 Monetary Union Without Fiscal Coordination May Discipline Policy Makers, Roel M. W. J. Beetsma and A. Lans Bovenberg 100 International Risk Sharing and European Monetary Unification, Bent E. Sorenson and Oved Yosha 105 Out in the Sunshine? Outsiders, Insiders, and the United States in 1998, Fabio Ghironi and Francesco Giavazzi 109 Participants 113 ©International Monetary Fund. Not for Redistribution Preface THE ONGOING PROCESS OF ECONOMIC INTEGRATION IN EUROPE—with monetary integration and the creation of a single European cur- rency critical elements of the process—has renewed interest in the concept of an optimum currency area. In recent years, many economists have written in search of an appropriate analytical framework to permit the evaluation of the requirements for, and consequences of, monetary integration. And, as is often the case, they begin with the concept of an optimum currency area pioneered by Robert A. Mundell in 1961. This volume is the result of a December 1996 symposium on optimum currency areas, held in Tel Aviv and sponsored by the Bank of Israel, the IMF, and Tel Aviv and Hebrew Universities. The symposium, and this book, honor Robert Mundell and his seminal contribution to this and many other important topics. They do that in part by providing an oppor- tunity for him to reflect on and update his thinking on the subject, and by asking other distinguished experts to present their views on the theoreti- cal and policy-oriented implications of Mundell's original contribution— and its relevance for European economic and monetary union (EMU). The run-up to the launching of EMU on January 1, 1999, is indeed a heady period, given the scope and magnitude of the project. The IMF re- cently hosted a conference on EMU and its implications for the IMF and for the international monetary system, which considered the issues of timing, the euro's strength as a currency, the impact on the stability of exchange rates, and how the IMF should adapt. This timely book sheds light on many of the relevant issues. It offers thoughts and concepts that extend and clarify the analytical framework for assessing the implications and consequences of EMU, which is clearly the most important outstanding issue for the international mone- tary system. It is entirely appropriate for the IMF to salute, on his sixty-fifth birth- day, Bob Mundell, whose work—some of it done at the IMF—guides so 1 ©International Monetary Fund. Not for Redistribution 2 • SUMMARIES OF PAPERS many of us in our thinking about exchange rates and the international economy. To Bob we say, well done and thank you for all you have contributed. Stanley Fischer First Deputy Managing Director International Monetary Fund ©International Monetary Fund. Not for Redistribution Acknowledgments THE DISCUSSIONS HELD IN TEL AVIV during the December 4-6, 1996, conference, "Optimum Currency Areas: The Current Agenda for International Monetary and Fiscal Integration," commemorated the thirty-fifth anniversary of Robert Mundell's seminal article on opti- mum currency areas. They also sought to shed light on the relevance of OCA theory for the impending European economic and monetary union. We would like to extend our appreciation to Robert Mundell for his updating of the agenda for monetary union provided in Tel Aviv and to all participants in the conference. We are especially grateful to the joint sponsors of the conference: the Bank of Israel, the International Monetary Fund, The Pinhas Sapir Center for Development and The Rubinstein Foundation at Tel Aviv University, and The Helmut Kohl Institute for European Studies at the Hebrew University of Jerusalem. Thanks are also owed to Nava Ganor, for her organizational support, and to Lijun Li for wordprocessing. Mario I. Blejer Jacob A. Frenkel Leonardo Leiderman Assaf Razin David M. Cheney 3 ©International Monetary Fund. Not for Redistribution This page intentionally left blank ©International Monetary Fund. Not for Redistribution 1 Introduction ©International Monetary Fund. Not for Redistribution This page intentionally left blank ©International Monetary Fund. Not for Redistribution Introduction Mario I. Blejer, Leonardo Leiderman, and Assaf Razin Dealing with intellectual history and, in particular, contemporary intellectual history, is indeed a dangerous undertaking. Any at- tempt to ascertain the origin of ideas and pin them down to a definite source always seems to raise a scholarly challenge and to invite claims that the idea under discussion has already been the subject of consideration and deliberation. Evidently, however, not everything has been said before. And certain ideas can be traced, without too much ef- fort and without generating too much controversy, to their precise intel- lectual source. That is, indeed, the case of the theory of optimum currency areas, pi- oneered by Robert A. Mundell in the 1960s. In his classical article, pub- lished in 1961 in the American Economic Review and reprinted in this book, Mundell defined the notion and posed, for the first time, the opti- mum currency area (OCA) problem. His paper generated an immediate chain reaction, with later contributions extending, improving, qualifying, and building upon the concept. The practical implications of the theory, however, did not appear to have particularly immediate consequences, except perhaps in the context of the fixed-versus-flexible-exchange-rate debate. Therefore, interest in the subject appears to have faded over time. The dynamics of the current process of economic integration in Europe have clearly reversed that trend. Developments in Europe have been such that, by the second half of the 1980s, the issue of monetary unification and the creation of a single European currency became the centerpiece of the integration process. It could be claimed (Eichengreen, 1993) that the momentous enterprise of creating a single currency in Europe is neither the exclusive product of analytical thinking, nor a nec- essary corollary of the materialization of the single market in capital, labor, and goods—but rather the consequence of political economy 7 ©International Monetary Fund. Not for Redistribution 8 • INTRODUCTION considerations. Even if this is so, it is still true that the debate over mon- etary unification in Europe has prompted an intense search for an ap- propriate analytical framework to allow an adequate evaluation of the requirements and consequences of the process. Invariably, the point of departure of this search has been Mundell's concept of an optimum cur- rency area. This notion has, therefore, returned to center stage of eco- nomic policy debates, and as European economic and monetary union (EMU) draws nearer, it is important to focus again on the theoretical, an- alytical, and policy-oriented implications of Mundell's seminal contribution. As Corden (1993) recently pointed out, re-reading Mundell is a re- warding experience. Despite the rapid transformations of world eco- nomic conditions, the central part of Mundell's analysis stands up well and continues to be highly relevant. The core of his thesis