I. Introduction

The breakups of the former Soviet Union and Yugoslavia and the reuniting of the two Germanies are among the most dramatic events in modern history. These are huge political events with correspondingly huge economic implications. Developing the cross-country currency and clearing arrangements for these emerging sovereigns is a high priority since pre-existing trading arrangements setup these new nations as each others’ primary trading partners. For many years the academic literature has studied the design of cross-country monetary arrangements, but in recent years the literature has become very complex and the data requirements necessary for appropriate application of the principles developed in the literature are far beyond the means of the emerging nations. Still, these nations need to make decisions about their currency arrangements. The purpose of this paper is to review briefly and formalize some of the existing literature on the optimal choice of currency area and then extend that literature in a direction that may be helpful for currency area decisions in a situation where little is known about the current economic situation and structure in these new nations.

Roughly, currency area choice is the choice between fixed and flexible exchange rates. A newly sovereign nation needs some initial property rights enforcement mechanism and needs an initial allocation of property rights to individuals and to the state. We will assume that the rights to make choices about money reside with the state. We will also assume that for public finance reasons the state issues its own money. Once it has decided to issue its own money, the country needs to choose between fixed and flexible exchange rates. ^1/

In Section II we review some of the original exchange rate regime literature and discuss some subsequent developments. In section III we develop a simple formal model that is capable of capturing some aspects of the early discussions. In section IV we provide extensions of the model and indicate the model’s implications for currency area choice.

II. Fixed Versus Flexible Exchange Rates and the Optimal Currency Area

Following WWII the International Monetary Fund was designed and implemented to facilitate aggregate cross-country commercial transactions. The Fund was conceived as an institution responsible for short-term lending primarily for balance of payments purposes and in defense of a system of fixed but adjustable exchange rates. Worldwide capital markets were poorly developed at the time, and the Fund acted as an official version of the yet to be developed international financial structure. Measured on the basis of the size and frequency of exchange rate changes, the Fund’s early years were a success. However, not everyone agreed on such a standard of measurement.

In 1953 Milton Friedman published “The Case for Flexible Exchange Rates,” which was conceived as a reply to the widespread adoption of the Bretton Woods fixed rate system. ^1/ Friedman’s case rested on market-determined exchange rate changes being, in his view, the best way for countries to accommodate cross-country demand shifts. His alternatives to flexible exchange rates involved either: (1) changes in official exchange rates, (2) changes in countries internal prices and incomes, (3) direct controls, or (4) the use of monetary reserves. In Friedman’s view the Bretton Woods system, which the Fund administered, relied excessively on option (1) and, he felt, that the crises that would surround currency realignments would be a much greater disturbance to economic activity than would be market-determined exchange rate movements. The other three alternatives were dismissed as: impractical for option (2) because of sticky prices and wages, too unpredictable for option (3) because of difficulties in predicting and monitoring imports, exports and capital flows and too restrictive for option (4) since reliance on monetary reserve flows to correct cross-country disturbances allows external considerations to dictate domestic monetary policy.

Friedman’s case was rejoined by Robert Mundell in his article “A Theory of Optimum Currency Areas,” in which he pointed out that a world in which all countries maintain fixed exchange rates, and a world with all countries maintaining flexible exchange rates are polar extremes, and an ideal cross-country monetary system probably lies in an arrangement wherein some countries join in a currency area maintaining fixed rates or possibly adopting a single currency, and other countries, not joining the currency area, float relative to the currency area. According to Mundell’s ideas, the currency area and the region of labor mobility are roughly the same. Since, by definition, labor cannot move across regions of labor mobility and with prices and wages sticky the only way to meet shocks in the demand for one region’s product relative to another region’s product, without causing unemployment or inflation, is to change the exchange rate between the regions. If labor were mobile between the regions then laborers could just migrate to booming areas and no exchange rate change would be necessary.

Mundell’s ideas were clear but they were hard to model formally and models evaluating exchange rate regime choice moved away from those ideas and toward looking at the composition of production, the stochastic structure of shocks, and more recently to signal extraction and credibility arguments. ^1/ It is our intention to revisit the optimum currency area problem and confront it on the same terms as the original contributors, but to try to sharpen the original arguments by putting them in terms of a formal model with an explicit stochastic structure. We will develop a model in which labor can move across regions--at a cost. And in which labor is induced to move by regional productivity and demand shocks. In the text we treat explicitly the case of negatively correlated productivity shocks. In our model, the choice of exchange rate regime will matter for real variables for the same reasons Mundell conjectured: nominal wages are sticky and as other prices change relative to wages, labor allocations are affected. The model in the text is the simplest case that illustrates our point, which is that Mundell may have understated his case for fixed exchange rates across regions of labor mobility. Our model makes Mundell’s point even more strongly than he made it originally, because we allow supply-side shocks to drive a wedge between the productivity of labor in a pair of countries thus giving rise to strong efficiency reasons for labor to move across national borders. Fixed exchange rates provide a monetary equilibrium in which labor will move for such efficiency reasons. Flexible exchange rates discourage labor mobility and thus provide an environment in which productivity difference are not be exploited.

III. A Model of Labor Mobility

We consider, at the outset, a minimal model capable of addressing the implications of labor mobility: a two countries, one good economy. ^2/ The effective supply of labor (denoted by EF) is given by:

where 0 ≤ c ≤ 1, 0 ≤ τ and where $\overline{\mathrm{L}}\mathrm{,}{\mathrm{L}}^{\mathrm{*}}$, denotes full employment at home and abroad respectively. ${\mathrm{L}}_{\mathrm{h}}^{*}$ denotes the foreign labor employed by the home economy, and L_f is the employment of home workers by the foreign economy. Employment of the domestic labor force beyond the full employment is subject to diminishing effectiveness, as is reflected by τ. Employing foreign labor at home is associated with a cost, measured by c. This term reflects transportation and time costs associated with the reallocation of workers across countries, implying that the effective supply of a reallocated worker is 1-c. Henceforth, we will normalize the supply of labor in each country to 1.

In our setup behavior is asymmetric at full employment. Labor’s effective supply falls one-for-one as domestic labor input is reduced below full employment. However, as domestic labor is increased beyond full employment its marginal effectiveness decreases. For simplicity we have adopted a quadratic form for the decreased effectiveness of domestic-based labor input beyond full employment.

The production function exhibits diminishing marginal product to effective labor input:

where Y and Y^* are domestic and the foreign output, which are assumed to be identical, and 1/a and 1/a^* correspond to domestic and the foreign productivity. The domestic money price of output is P and P^* is the foreign money price of output. Since Y and Y^* are identical the law of one price gives P = P^*S, where S is the exchange rate, quoted as the domestic currency price of the foreign currency.

b. A fixed exchange rate

From the global point of view, the two states of nature result in with the same price level, and hence the same real wage. This is an outcome of the symmetry of the shocks and the fact that under a fixed exchange rate the money market (which determines the price level P) is global. Hence, the global GNP, given by Y + Y^*, is the same in the two states of nature. Assuming a given global supply of money, it implies that the price level is the same. While the results of our analysis do not hinge on the constancy of the real wage across state of nature, exposition of the key points is greatly simplified by this feature. Figure 1 depicts the equilibrium in home economy labor market. Similar analysis is applicable to the foreign country. Figure 1 plots the marginal product of labor employed by the home economy is states A and B (denoted by MP_L,A and MP_L,B, respectively). The real wage is given by $\frac{W_o}{P_o}$. In state A domestic employment exceeds the full employment level. Equation (1) implies that as long as the marginal contribution of domestic labor to the effective labor exceeds 1-c, the producer will employ only domestic workers. Once that equality is reached, the domestic producer will employ $1+\frac{c}{\tau }$ domestic labor, and will employ foreign workers as to equate their marginal product (net of reallocation cost) to the real wage. Figure 1 summarizes these possibilities, where curve ${MP}_{L,A}^{N.M.}$ corresponds to the marginal product of labor in the absence of labor mobility, and curve ${MP}_{L,A}^{L.M.}$ corresponds to the case where mobility of labor is allowed. The two curves diverge at point M, once that the domestic employment exceeds the full employment by a fraction $\frac{c}{\tau }$. The extent of the mobility of labor is determined by the magnitude of the shocks. For large shocks, the cost of reallocation is small relative to the demand in the country experiencing the favorable productivity shock, as is depicted in Figure 1a. In state A domestic employment will be $1+\frac{c}{\tau }$ and in addition ${\mathrm{L}}_{\mathrm{n}}^{*}$ foreign workers will be employed by domestic producers. The symmetry of the two countries implies that in state B only L_B workers will be employed by the home economy producers, and ${\mathrm{L}}_{\mathrm{f}}={\mathrm{L}}_{\mathrm{h}}^{*}$ domestic workers will reallocate and will be employed by foreign producers. Figure 1b corresponds to the case of small shocks, such that at resultant equilibrium the real wage exceeds the marginal product of foreign labor. For large shocks, the country experiencing the positive shock will employ foreign workers. Labor will move if the marginal product of labor at point M exceeds the real wage, as is the case in Figure 1a. Note that in such a case the condition of full employment implies that the wage contract is set such that:

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THE LABOR MARKET

Citation: IMF Working Papers 1992, 039; 10.5089/9781451845747.001.A001

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THE LABOR MARKET

Citation: IMF Working Papers 1992, 039; 10.5089/9781451845747.001.A001

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$\begin{array}{cc}\frac{1}{2}({\mathrm{L}}_{\mathrm{B}}+{\mathrm{L}}_{\mathrm{f}})+\frac{1}{2}(1+\frac{\mathrm{c}}{\tau })=1.& \left(7\right)\end{array}$

From which we infer that the variance of the home labor force employment is:

$\begin{array}{cc}\text{Var}\left(\mathrm{L}+{\mathrm{L}}_{\mathrm{f}}\right)={\left(\frac{\mathrm{c}}{\tau }\right)}^2,& \left(8\right)\end{array}$

where Var(z) denotes the variance of z. In terms of Figure 1a, the standard deviation of employment is given by the horizontal distance between points M and 1. In the Appendix we show that labor will be reallocated if h is large enough, such that $\mathrm{h}>\mathrm{c}\frac{2(1-\gamma )+\tau }{2\tau }$.

IV. The Effect of Changing Labor-Mobility Costs

We can apply our methodology to study the impact of a drop in the labor reallocation cost, c. This exercise is summarized in Figure 2. Suppose that we start in an equilibrium where the magnitude of the productivity shock (h) is large enough to induce labor to move. A lower mobility cost c will encourage the reallocation of labor, shifting point M up to M′. At the initial real wage, total employment in state A, $\left(1+\frac{\mathrm{c}}{\mathrm{\tau }}+{\mathrm{L}}_{\mathrm{h}}^{*}\right),$, will go up. Recalling that the wage contract is preset as to yield expected employment of 1, we deduce that a drop in c will induce a rise in the contract wage, from ${\left(\frac{\mathrm{W}}{\mathrm{P}}\right)}_{\mathrm{o}}$ to $\left(\frac{\mathrm{W}}{\mathrm{P}}\right)$. This will increase the fluctuations of employment in a given country by ϵ, while it reduce the volatility of the employment of the labor force of each country by the horizontal distance between points M and M′. The expected GNP will go up by the shaded area in Figure 2.

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REALLOCATION COST, OUTPUT AND EMPLOYMENT

Citation: IMF Working Papers 1992, 039; 10.5089/9781451845747.001.A001

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We summarize these observations with the help of Figure 3, tracing the expected GNP and the volatility of employment (as measured by the variance of employment). If the labor reallocation cost is zero, a fixed exchange rate regime is associated with an equilibrium at point FIX(c=0), whereas a flexible exchange rate is associated with an equilibrium at point FLX. With costlessly mobility of labor, the two countries are fully integrated under a fixed exchange rate regime. The negative correlation among the productivity shocks implies that the sum of the two production functions is nonstochastic. Labor will be reallocated among the two counties in a way that will eliminate the volatility of employment from the viewpoint of labor, while it maximizes the volatility of employment from the producers point of view. In such an environment, the marginal product of labor is equated across all producers, and hence the expected GNP is maximized. In these circumstances, flexible exchange rate will operate as an obstacle for the efficient reallocation of labor: it will generate wedges between the real wages in the two countries due to the adjustment of the exchange rate. In our case, it will eliminate the incentive to reallocate labor, hence employment will be stable for both workers and producers. The lower expected GNP under a flexible exchange rate regime reflects the inefficiency introduced due to the inequalities between the marginal product of labor.

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EXPECTED OUTPUT AND THE VARIANCE OF EMPLOYMENT

Citation: IMF Working Papers 1992, 039; 10.5089/9781451845747.001.A001

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The effect of higher transportation cost c is to shift the point representing fixed exchange rate to FIX(c > 0). The reallocation cost reduces the ability to smooth employment, increasing thereby the volatility of employment from the point of view of labor. A by-product of the lower mobility of labor is a corresponding drop of the magnitude of labor reallocated from a low marginal product activity towards a high marginal product activity. This has the efficiency cost in the form of reducing the expected GNP. Applying the logic of Figure 1, it follows that expected GNP under a fixed exchange rate regime exceeds expected GNP under a flexible exchange rate regime by a margin that depends negatively on the reallocation cost.

V. Review

We may summarize the insights of this analysis in the following way:

a. Regions whose labor market is segmented face a trade-off in making the choice regarding the proper exchange rate regime: a fixed exchange rate regime is associated with a higher expected GNP, as well as a higher volatility of employment relative to a flexible exchange rate regime. In these circumstances, a flexible exchange rate regime operates as a costly employment stabilizer. The magnitude of this cost goes up the higher is the integration of the labor markets of the various regions.

b. Regions that are fully integrated into a common labor market will unambiguously benefit from sharing the same currency, or alternatively adopting a fixed exchange rate regime.

c. Steps that increase the integration of labor market across regions will increase the benefits from adopting fixed exchange rates, by increasing expected GNP under a fixed exchange rate and reducing the volatility of employment.

d. If increasing the integration of regional labor markets is not feasible, mechanisms that will stabilize regional employment will enhance the benefits of a fixed exchange rate. While our model ignores the fiscal side and the presence of non-traded goods, we can add them into our model. In such an environment, a federal tax system that reallocates resources from regions that undergo an expansionary period towards regions that undergo a recessionary episode will be beneficial in reducing the volatility of employment under a fixed exchange rate system (as may be the case in the United States, see Martin and Sachs and (1991)).

e. Our analysis was confined to productivity shocks. One can extend it to account for monetary shocks. It is easy to show that monetary shocks will increase the benefits from a fixed exchange rate: monetary shocks will depress the expected output under a flexible exchange rate, and will increase the volatility of employment. These effects are absent (or weaker) under a fixed exchange rate regime, due to its ability to isolate the labor market from monetary shocks.

We simplified the analysis by assuming a fixed velocity of the demand for money. Allowing for a flexible velocity specification will not affect the qualitative nature of our results, while it will change the solution. For example, our result that a flexible exchange rate stabilizes completely the employment in the presence of productivity shocks will not hold, but employment will fluctuate less under a flexible exchange rate regime.

f. Our model ignored the role of investment and capital mobility. Allowance for capital mobility in the form of foreign direct investment will have similar qualitative effects as allowing for the mobility of labor: it will enhance the expected GNP, and will increase the volatility of employment under a fixed exchange rate relative to a flexible exchange rate regime (see Aizenman (1991)). This suggests that allowing for the mobility of both capital and labor will magnify the beneficial effects of fixed exchange rate, by stabilizing the employment while increasing the GNP. The message of this result is simple: acts that increase the economic integration of regional labor and capital markets are beneficial by working as to equalize the value of the marginal productivity of inputs across regions. As a by product, steps that increase the integration of markets will tend to reduce the benefits of multiple currencies.

VI. Final Remarks

Our formal modeling has served to underscore Mundell’s original insight: in a situation where wages are sticky and the costs of factor mobility are low, fixed exchange rates may help move the economic system toward an efficient allocation of resources. This insight can provide an organizing focus for an emerging country choosing whether to adopt a larger county’s currency. The principle allows the emerging country to first consult its revenue requirements and inducements offered by the larger country. If these first-order issues make the large country currency attractive then the principle says to look to the extent of factor mobility and to the impediments to factor mobility. If these impediments are low or can be made low through negotiations then joining the large country may offer some efficiency gains.