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Special Topics in Economics Econ. 491

Special Topics in Economics Econ. 491. Chapter 3: Optimum Currency Area ( OCA ). The currency crises in Mexico (1994), Asia (1997), Russia (1998),& Brazil (1999) have fueled the debate on the optimal choice of exchange rate regimes.

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Special Topics in Economics Econ. 491

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  1. Special Topics in Economics Econ. 491 Chapter 3: Optimum Currency Area ( OCA )

  2. The currency crises in Mexico (1994), Asia (1997), Russia (1998),& Brazil (1999) have fueled the debate on the optimal choice of exchange rate regimes. • The determinants of exchange rate policy have been examined empirically using models based on the theory of Optimal Currency Areas (OCA). I. Theory of Optimum Currency Areas (OCA)

  3. The theory was developed by Robert Mundell in 1961. • The theory of optimum currency areas argues that the optimal area for a system of fixed exchange rates, or a common currency, is one that is highly economically integrated. • This theory stresses that there is no single exchange rate policy that performs best for all countries (Mundell, 1961). • Economic Integration states FTA, Customs Union, Common Market, Monetary Union.

  4. Monetary union consists of : (Unified Common Currency– Unified Central Bank ) • A common currency ( a single currency zone, monetary union) is one where the accepted means of payment consists of a single homogeneous currency linked by an exchange rate that is fixed ( at one for one) irrevocably. • Monetary union can be viewed as the extension of a fixed exchange rate regime to a point where the possibility of parity changes is ruled out completely. • Can USA be an OCA? II. Monetary Union ( Common Currency)

  5. Costs of common currency are that they require the loss of monetary policy for stabilizing output and employment, and the loss of automatic adjustment of exchange rates to changes in aggregate demand. How !! • Other cost is that the loss of country’s sovereignty . How !! III. Costs of the Monetary Union ( Common Currency)

  6. A common currency (Fixed exchange rate) has costs and benefits for countries deciding whether to adhere to them. • The ultimate goal for the MU is to increase the level of bilateral trade. • Benefits of common currency are that they avoid the uncertainty and international transaction costs that floating exchange rates involve. • Reducing the transaction costs • Reducing the exchange rate volatility IV. Benefits of the Monetary Union ( Common Currency)

  7. How does a region determine whether a currency area would provide net benefits? • The literature on optimal currency areas suggests that a region is likely to gain from a common currency if: • A large share of members’ trade occurs with other members. How!! 2) The region is subject primarily to common shocks that affect the entire area similarly & not to shocks that affect sub-regions differently. How!! V. Who Should Use a Common Currency

  8. 3) Labor is mobile within the region. How!! 4) A tax-transfer system exists to transfer resources from sub-regions performing strongly to those performing poorly. How!!

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