6. Optimal Currency Areas: A Review of the Recent Literature

Principles of Macroeconomics (with Xtra!)

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Bank of Canada Banque du Canada Working Paper 99-16 / Document de travail 99-16 Optimal Currency Areas: A Review of the Recent Literature by Robert Lafrance and Pierre St-Amant
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ISSN 1192-5434 ISBN 0-662-28180-2 Printed in Canada on recycled paper
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Bank of Canada Working Paper 99-16 October 1999 Optimal Currency Areas: A Review of the Recent Literature by Robert Lafrance and Pierre St-Amant International Department Bank of Canada Ottawa, Canada K1A 0G9 E-mail: pstamant@bank-banque-canada.ca The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada.
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iii Contents Acknowledgements. ............................................................................................................. iv Abstract / Résumé. ................................................................................................................ v 1. Introduction. .......................................................................................................................... 1 2. Modelling the principles of optimal currency areas . ............................................................ 1 2.1 Optimal currency areas in general-equilibrium models with price rigidities . ............. 2 2.2 General equilibrium and the completeness of asset markets . ...................................... 5 3. Assessing criteria for optimal currency areas. ...................................................................... 6 3.1 Measuring asymmetry. ................................................................................................. 6 3.1.1 Shocks and business-cycle asymmetry measured with VARs. ........................... 6 3.1.2 Differences in the transmission mechanism of monetary policy. ....................... 8 3.1.3 Optimal currency areas and the volatility of real exchange rates. ...................... 9 3.1.4 Cluster analysis and principal components. ...................................................... 10 3.1.5 Regional/industrial disaggregation . .................................................................. 11 3.2 Assessing compensating adjustment mechanisms. .................................................... 12 3.2.1 Labour mobility and wages flexibility. ............................................................. 12 3.2.2 Fiscal federalism. .............................................................................................. 13 3.2.3 The role of market mechanisms in smoothing consumption . ........................... 14 3.3 How exchange rate regimes affect optimal currency area criteria. ............................ 17 4. Using optimal currency area criteria to explain exchange rate movements . ...................... 18 5. Exchange rate flexibility and macroeconomic stability. ..................................................... 19 6. Productivity and the exchange rate. .................................................................................... 20 7. Conclusion .................................................................................................................... 23 Bibliography .................................................................................................................... 25
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iv Acknowledgements We would like to thank Chantal Dupasquier, Doug Hostland, John Murray, Patrick Osakwe, James Powell, Larry Schembri, David Tessier, Rodrigue Tremblay, and participants of the June 1999 Canadian Economics Association meeting and the June 1999 meeting of the Société canadienne de Science économique for useful comments and discussions.
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v Abstract This paper surveys the recent literature on optimal currency areas (OCAs). Topics that are covered include theoretical developments in the context of general-equilibrium models and empirical work on shocks asymmetry and adjustment mechanisms. Issues relating to the endogeneity of OCA criteria, the role of exchange rate flexibility in promoting greater macroeconomic stability, and the links between productivity and the exchange rate are also surveyed. We conclude with suggestions for future research. JEL classifications: E42, F33 Bank of Canada classification: Exchange rate regimes Résumé Les auteurs font un survol des études consacrées récemment aux zones monétaires optimales. Ils analysent l’évolution de la théorie dans un contexte d’équilibre général et passent en revue les travaux empiriques portant sur l’asymétrie des chocs et les mécanismes d’ajustement.
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6. Optimal Currency Areas: A Review of the Recent...

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