And if a Monetary Union Is Better?

FIXED EXCHANGE RATES OR FLEXIBLE ONES? MONACELLI EXPLAINS WHY THE LATTER DO NOT WORK UNDER CERTAIN CONDITIONS

A fixed exchange rate regime is not considered desirable when an asymmetric shock hits a country. A flexible exchange rate is preferable because it operates as an insurance mechanism for a country fallen into recession. A monetary union is an irrevocably fixed exchange rate regime. It is thus not desirable unless completed by a fiscal union that delivers redistribution and transfers between countries.

This idea is explored by Tommaso Monacelli and Dominik Groll in The Inherent Benefit of Monetary Unions. The authors show that under certain conditions a monetary union regime is more desirable than a flexible exchange rates regime. “The traditional idea that flexible exchange rates are preferable is right only under full commitment, this is to say in an unrealistic world where the monetary authority is able to influence the private sector’s expectations”.

In a more realistic world, the authority acts under discretion. A fixed exchange rate induces inertia in the behavior of the terms of trade and inflation. This inertia acts as a commitment device, thereby improving on the policymaker’s ability to manage expectations. “In a fixed exchange rate regime, the competitive equilibrium is adjusted over time. Under certain conditions, it more than compensates for the loss of flexible rates”. The study rejects the idea that a monetary union is only convenient for countries with a strong monetary authority or for those who bond to a strong country. It is a good deal also when it is secured by two countries starting from a sub-optimal status. The monetary union gives them the reliability they are lacking.

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by Claudio Todesco