The Economics of Common Currencies

Proceedings of the Madrid Conference on Optimum Currency Areas

Harry G. Johnson, Alexander K. Swoboda, Harry G. Johnson, Alexander K. Swoboda

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781135055257
• Edition: 1
• Topic: Economía
• Subtopic: Teoría económica

Gathering together the papers presented at the Madrid Conference on Optimum Currency Areas in 1970 this volume represents one of the first complete surveys of the theory and policy implication of monetary integration. The book discusses:

• the economics of fixed exchange rates relevant to monetary relations within an integrated monetary area

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• the evolution of economic doctrine and a survey of optimum currency area theory

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• problems of policy co-ordination within a currency area

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• relevance of the monetary-fiscal policy mix

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• problems of monetary union in developing countries

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• the book predicted the establishment of an European currency but presented the case for greater flexibility of exchange rates as an alternative to currency unification.

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PART I

THE ECONOMICS OF FIXED EXCHANGE RATES

Chapter 1

TWO ARGUMENTS FOR FIXED RATES*

ARTHUR B. LAFFER

University of Chicago

Few issues in economics have inspired so much debate as the issue of the relative desirability of flexible, pegged and fixed exchange rate systems for the world economy. Each system has its proponents, but at the moment by far the most favoured among economists is the flexible exchange rate system. In this paper two purely theoretical arguments are presented which tend to favour fixed exchange rates.¹ The first argument focuses on the efficiency of the adjustment process under conditions of anything other than a perfectly flexible price level and the second on the efficiency of the allocation of real resources under equilibrium conditions. Given the current state of the debate, I take a system of flexible exchange rates as the alternative to a permanently fixed exchange rate system.

As a purely theoretical matter, flexible and permanently fixed exchange rates can be differentiated by the ability of the private sector of an economy to vary the nominal quantity of domestic money via the balance of payments.² If, other things being equal, the private sector of the economy in question can alter the nominal stock of domestic money, then this economy is operating with fixed exchange rates. On the other hand, with a flexible exchange rate system, the private sector of the economy cannot alter the nominal quantity of money. With fixed exchange rates, since the domestic currency price of foreign exchange is by definition fixed, the nominal quantity of money will move in response to induced balance-of-payments changes.³ With flexible exchange rates the nominal quantity of domestic money is determined solely by the domestic government and is completely unresponsive to the prevailing private demand conditions for money via the balance of payments. The price of foreign exchange, however, is free to move, continually equilibrating the private demand for and supply of foreign exchange.

Much of the case for flexible exchange rates has been founded on the presumed short-run unresponsiveness of domestic prices, in the downward direction at least.¹ In the flexible exchange rate literature perfect level flexibility with fixed exchange rates is argued to be theoretically undifferentiable from a world of price level rigidities and flexible exchange rates.² It must be emphasized that when we concern ourselves with the adjustment process, price level rigidities must be assumed in order to give meaning to any discussion of fixed and flexible exchange rates.

An additional assumption ubiquitously implied in the literature is that each country’s government has and exercises a complete hegemony over the country’s nominal supply of domestically used money. Thus, when residents of a country transact with each other, they transact in the local numeraire currency, and the money balances they hold backing those transactions are denominated in the local currency.³ The currency denomination backing international transactions is also pre-specified and does not change. Transactors between the United States and Britain therefore hold either dollars or pounds, but irrespective of the circumstances, cannot costlessly substitute either one for the other. Thus, by law the individual monies of the world are made imperfect substitutes – the supply of each being controlled by the local government.

By a flexible exchange rate system is meant a system whereby the governments in question do not attempt to alter or control the price of their currencies relative to other currencies. In the strictest sense, a flexible exchange rate system ceteris paribus is a private system. A fixed exchange rate system is a system whereby the government of each and every country supplies to anyone any amount of domestic money when demanded, in exchange for any foreign money at a predetermined unchanging ratio. In the strictest sense a fixed exchange rate system ceteris paribus is a government system. In order to simplify the analysis, transportation costs among countries are set at zero – e.g. all goods are perfect tradables.¹ As is customary, labour is assumed to be perfectly immobile among countries in the short run. To simplify the analysis and to avoid a complex set of irrelevancies with respect to the arguments made here, it is assumed that labour is the only factor of production. It is also assumed that some of every good is produced in each country, thus ensuring that for any good the marginal revenue product of labour is equal to the wage rate. This assumption is in many respects tantamount to assuming that there is only one good in the world.²

I EQUILIBRIUM AND EFFICIENT ADJUSTMENT

Fully employed, efficiently utilized factors of production (here assumed only to be labour) within countries and factor price equalization among countries, broadly define equilibrium. By earlier assumptions the domestic price of each good must simultaneously equal (i) the domestic wage rate divided by the marginal product of labour, and (ii) the foreign price of the good converted at the foreign exchange rate. The domestic wage rate must equal the foreign wage rate converted into domestic currency units at the market rate of exchange, even though labour is assumed to be a non-traded good among countries. The final condition for equilibrium is that, given efficient utilization of the entire labour force and a single world price for any one good, the nominal supply of money in the country precisely equals the nominal demand for money – the demand for money being positively related to the level of real output and the price level and negatively related to the rate of interest. Alternatively, given that labour is assumed to be the only factor of production, actual employment and the nominal wage rate could be substituted for the level of real output and the price level respectively.

The model described above is similar to the bulk of macro-models. In general, we use the model elaborately described by Professor Friedman [3]. Our analysis will evolve from the question: given the equilibrium position for one small country what happens if this country’s government decreases the stock of money?¹ Save the origin of the disturbance, this is virtually the same example as is commonly used to propound the relative merits of a flexible exchange rate system.

Under flexible exchange rates with price rigidities we would have the following scenario for the ‘small country’ economy in question. A decrease of the money stock would lead to an excess demand for money. The private sector would attempt to sell more goods and buy less at the prevailing rigid market price for goods in order to accumulate additional money balances. Because labour is the only factor of production an excess supply of goods is equivalent to an excess supply of labour.

The excess supply of labour – the excess supply of goods – matched by an excess demand for money leads directly to a reduction in the level of employment and will have no effect on foreign exchange rates. Only in this way can the demand for money be brought into accord with the new supply of money. Because the price level, e.g. the nominal wage, cannot fall and the nominal quantity of money cannot increase, adjustment occurs through a fall in output and employment. The exchange rate will not change as a consequence of the one market price rule.

In a Keynesian type of system, which in this case requires that domestically produced goods be imperfect substitutes for foreign goods, a decline in the stock of money will cause a rise in the domestic interest rate. Investment will fall, causing a fall in output and employment. The fall in output leads to an incipient reduction in the domestic demand for imports. Trade must, however, be balanced because of flexible rates, thus implying that the price of the domestic currency in terms of foreign exchange must rise – the domestic currency appreciates. Through the improvement in the terms of trade, several forces will be set in motion. The substitution effects will be such as tend to increase the marginal propensity to import as well as the import function’s intercept (i.e. the level of imports implied by the tangency line to the import function when income equals zero). The substitution effects also will tend to reduce the physical volume of domestically produced goods sold to foreigners. All these forces operate to further the decline in output and employment beyond what would have occurred had the exchange rate not been free to move.

Introducing bonds into the analysis and allowing for gradual adjustment of the price level does not alter the above conclusions and may even make the incidence of unemployment in this Keynesian economy even more severe. The degree to which the excess demand for money is matched by an excess supply of goods as opposed to an excess supply of bonds, does not change the employment results. The interest rate is determined in the world market and the price level of goods (the nominal wage) is given. Variations in real output (unemployment) are the only way to equilibrate the demand for and supply of money.¹

If the price level (or the nominal wage) is unable to adjust inst...