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Working Paper Summaries (WP/93/1 - WP/93/54)
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Summary of WP/93/20: “Monetary and Exchange Rate Arrangements for NAFTA”

Author(s):
International Monetary Fund
Published Date:
August 1993
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This paper considers the advisability of having a single currency across the North American Free Trade Area (NAFTA)--comprising the United States, Canada, and Mexico--through the dual lenses offered by the theory of optimum currency areas and the experience of the European Community (EC). In the EC, the Single Market Program has created growing momentum for deeper economic integration, of which a single European currency is regarded as an integral part. In North America, by contrast, the debate over economic integration has barely touched on altering current monetary arrangements.

In principle, the paper finds that the European Commission’s argument that reaping the full benefits of economic integration requires firmly fixed exchange rates, and ultimately a single currency for Europe, applies with equal force to North America. But the benefits of permanently fixing the exchange rate must be weighed against the costs of relinquishing it as an instrument of adjustment. To gain insight into these comparative costs, the paper analyzes the incidence of supply and demand disturbances to different North American regions and EC member countries.

The analysis suggests that the costs of truly fixed exchange rates (or monetary union) are likely to be higher for North America than for the EC’s continental core (Germany, France, Belgium, the Netherlands, and Denmark). Even when the entire EC is used for the comparison, the negative correlation of underlying shocks in Mexico with those to the industrial regions of the United States, and the exceptionally large magnitude of Mexico’s shocks, suggest that Mexico would incur higher costs than Southern Europe from a rigid currency link. This, the authors suggest, reflects the importance of petroleum production in the Mexican economy.

Of course, energy production is also important to the South Western United States and to Western Canada. The correlation between their shocks and those to their respective currency areas is also strikingly low, which is where other elements of optimum currency area theory come into play. Labor mobility between the South West and the rest of the United States and between Western and Eastern Canada is high and accompanied by relatively little social and political strain. Similarly, the United States and Canada both possess highly articulated systems of fiscal federalism that work to minimize the dislocations caused by region-specific shocks. While fiscal federalism is under active discussion in the EC, the creation of such institutions at the North American level has not been broached in NAFTA negotiations. For all these reasons, the paper concludes that North America is less of an optimum currency area than the EC.

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