Lecture 10 - Optimum Currency Area

Question 1

What is a nominal exchange rate?

Answer 1

The nominal exchange rate is the price of one currency in terms of another

Question 2

What factors affect exchange rates?

Answer 2

• Inflation
• Government budget deficits
• Sovereign funds

Question 3

State the formula for calculating the real exchange rate

Answer 3

Real exchange rate = Nominal exchange rate * relative prices (P/P) where P is the domestic price and P is the foreign price

Question 4

What is the relationship between the real exchange rate and the importer of a good/service?

Answer 4

• The real exchange rate matters for the welfare of the importer
• If the real ER of the pound against the euro becomes lower, then UK tourists to EU will be worse off

Question 5

How will a high real exchange rate affect a country’s ability to export goods?

Answer 5

A country with a high real exchange rate will find it difficult to export goods as they are expensive for foreign buyers

Question 6

What are the two ways a country can restore its competitiveness when they have a high real exchange rate?

Answer 6

1- Deflation: Reduce prices at home by cutting back demand and lowering costs, often leading to higher unemployment
2- Devaluation (fall in the nominal ER): effective in short-term but arguable impact longer term

Question 7

In the short run in the forex market, how does the exchange rate tend to overshoot?

Answer 7

• In the forex market, nominal exchange rate incorporates a multitude of factors that affect and reflect an economy’s performance
• But in the short run the exchange rate may tend to overshoot (go too far) and this can have a destabilising effect

Question 8

How does successful are governments usually when they try to stabilise the nominal ER?

Answer 8

• Governments are tempted to try and stabilise the nominal ER
• This can work in the short run but in the medium run it is more problematic: impossible trio

Question 9

What is the impossible trio?

Answer 9

1- Stable nominal ER (easier for traders)
2- Free trade and investment flows (more specialisation etc)
3- Independent monetary policy (better tuned to local conditions)
Each are desirable but in the medium term only 2 of 3 are sustainable

Question 10

What are the benefits and drawbacks of a common currency?

Answer 10

• Elimination of transaction costs (costs of exchanging one currency into another)
• Greater price transparency which will increase competition and efficiency
• Exchange rate uncertainty and price mechanism which can distort production and investment decisions and lenders will demand higher real interest rates

Question 11

What is Mundell’s theory?

Answer 11

• Mundell’s theory states that a monetary union between two countries is optimal if there is sufficient wage flexibility and or if there is sufficient mobility of labour

Question 12

If France and Germany were to form a monetary union and asymmetric shocks shifted aggregate demand away from French products to German products causing higher unemployment in France and inflation in Germany, how does Mundell’s theory of a MU suggest this will pan out?

Answer 12

With the MU, Mundell’s theory states that there are automatic mechanisms for restoring equilibrium:
- Wage flexibility will lower wages in France and raise them in Germany and therefore lower production costs in France relative to Germany and therefore restore France’s competitiveness and equilibrium
- Mobility of labour eliminates the need for wage adjustments

Question 13

Is the eurozone an optimum currency area (OCA)?

Answer 13

The EU15 is not an optimum currency area but there is a subset of EU countries which are such as Germany and France