MONETARY FACTORS AND EXCHANGE RATE MOVEMENTS

Monetary Factors and Exchange Rate Movements



Monetary Factors and Exchange Rate Movements

Introduction

Although the difficult technical problems of creating a new common money for Europe have been successfully overcome as nicely explained here by Otmar Issing, its economic advisability remains in dispute. Even on this panel itself, Martin Feldstein doubts that a one-size-fits-all monetary policy for all of continental Western Europe is at all appropriate—let alone extending the domain of the euro to include Britain and Sweden or countries further east. However, Dominick Salvatore has always favored the euro, while Rudiger Dornbusch—a reformed sinner—is only now in favor ex post facto.

The paradoxical mundell

Robert Mundell was recently awarded the 1999 Nobel Prize in economics for path-breaking theoretical contributions published in the 1960s on the ways monetary and fiscal policies work in open economies. His ideas are deeply embedded in textbooks on how the foreign exchanges constrain national macroeconomic policies.

But does Mundell deserve the additional sobriquet of “intellectual father of the euro”? Since 1970, he has enthusiastically advocated European monetary unification (EMU), and seems vindicated by the formal advent of the euro on January 1, 1999.

Therein lies a paradox. For more than a decade before EMU's advent, the fierce debate on whether a one-size-fits-all European monetary policy was appropriate for a diverse set of European countries pitted politicians, who, on the continent were mainly in favor, against economists who generally were much more doubtful. And the doubters who opposed EMU used arguments drawn from Mundell's own work! Specifically, Mundell's earlier classic article, “The Theory of Optimum Currency Areas,” published in 1961 in the American Economic Review comes down against a common monetary policy—and seems to argue in favor of making currency areas smaller rather than larger.

This paradox, where Mundell seems to be on both sides of the debate over European monetary unification, can be resolved by noting that there are two Mundell models—earlier and later. In two important papers written in 1970, but not published in an obscure conference volume until 1973, Mundell presented a different—and surprisingly modern—analytical perspective. If a common money can be managed so that its general purchasing power remains stable, then the larger the currency area—even one encompassing diverse regions or nations subject to “asymmetric shocks”—the better.

The earlier mundell with stationary expectations

Like most macroeconomists in 1961, Mundell still had a postwar Keynesian mindset in believing that national monetary and fiscal policies could successfully fine tune aggregate demand to offset private sector shocks—on the supply or demand sides. Underpinning this belief was the assumption of stationary expectations. As a modeling strategy, he assumed that people took the current domestic price level, interest rate, and exchange rate (even when the exchange rate was floating) as holding indefinitely.

The later mundell and international risk sharing

In a not-much-later incarnation, Robert Mundell jettisoned his earlier presumption of stationary expectations to focus on how future exchange rate uncertainty could disrupt the capital market by inhibiting international portfolio diversification and risk sharing. At a 1970 Madrid conference on optimum currency areas, he ...