Topic 11: Optimal Currency Areas & Exchange Rates

Question 1

Who developed the theory of optimal currency areas?

Answer 1

Robert Mundell in 1961.

Question 2

What are the advantages to currency areas?

Answer 2

• Microeconomic efficiency from eliminating exchang ecosts.
• Price comparisons easier and risk free.
• Advantage to having same money used in a wider area, as it is subject to network effects.

Question 3

What are the disadvantages to a currency area / union?

Answer 3

• Macroeconomic flexibility is reduced.
• If only a subset of the region experiences a shock, then monetary policy can’t meet it’s exact needs without having the ‘wrong’ policy for the rest of the region.
• When there is lots of rigidities and poor mobility, the process of shifing back to normal is very slow and painful without the flexible monteary policy.

Question 4

What are the conditions for an optimal currency area?

Answer 4

1. High internal factor mobility, low external factor mobility.
2. Regions possess similar production structures.
3. Regions have diversified economies, rather then specialized.
4. Regions open to international trade.
5. High internal price and wage flexability.
6. Similar inflation rates between nations.
7. Fiscal and monetary policies are intergrated between regions.

Question 5

How can RPPP be approximated?

Answer 5

%ΔS = %Δπ_d - %Δπ_f

Question 6

What is the implication of the international fisher effect?

Answer 6

That there is real interest rate parity.

i_AU ~= i_US + (π^e_AU - π^e_US)

iUS = rUS + πUS

r_AU = r_US

Question 7

What is the asset market theory of the exchange rates?

Answer 7

Reckognises that exchange rates are relative prices of assets determined in organised markets where prices can be adjusted on a moment to moment basis to whatever the market regards as the appropriate price,

Question 8

What does a BOP surplus mean in fixed rate regimes?

Answer 8

Domestic peeps are acquiring forieng currency. They will exchange it with the central bank to recieve d.c, so there is an increase in foriegn reserves and money demand.

The BOP surplus is the excess demand for money.

Question 9

Show the final reserve equation for fixed exchange regimes.

Answer 9

R = P x L(y,i) - D

Where L(y,i) is a function for money demand.

Question 10

What is the implication of various economic factors on reserves for a fixed exchange system?