Price Adjustment in Currency Unions: Another Dimension to the Endogeneity of the Optimum Currency Area Criteria?
| Author | Michael Bleaney,Lin Yin |
| DOI | http://doi.org/10.1111/obes.12235 |
| Date | 01 August 2018 |
| Published date | 01 August 2018 |
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©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 80, 4 (2018) 0305–9049
doi: 10.1111/obes.12235
Price Adjustment in Currency Unions:Another
Dimension to the Endogeneity of the Optimum
Currency Area Criteria?*
Michael Bleaney† and Lin Yin‡
†School of Economics, University of Nottingham, University Park, Nottingham NG7 2RD,
UK (e-mail: michael.bleaney@nottingham.ac.uk)
‡Economic Research Department, China Railway Party School, Beijing, China
(e-mail: 951298673@qq.com)
Abstract
In a rational expectations model, wages and prices should respond more to shocks in
currency unions than under adjustable pegs because of the absence of exchange rate ad-
justment. This is an aspect of the endogeneity of the optimum currency area criteria that
has been largely ignored. Empirical evidence from three currency unions tends to suggest
some degree of endogeneity of price flexibility, but the rate of adjustment is slow. Self-
selection into currency unions by countries with naturally greater price flexibility does not
appear to be a significant factor.
I. Introduction
Robert Mundell opens his seminal 1961 paper on optimum currency areas with the fol-
lowing statement: ‘[I]t is patently obvious that periodic balance of payments crises will
remain an integral feature of the international economic system as long as fixed exchange
rates and rigid wage and price levels preventthe terms of trade from fulfilling a natural role
in the adjustment process’. The literature has emphasised the importance of international
linkages between regions through the extent of trade, symmetry of shocks, labour mobility
and fiscal transfer mechanisms as criteria for a currency union. Frankel and Rose (1997)
added a new twist to the debate by noting the endogeneity of some of these criteria, show-
ing that the formation of a currency union itself tended to increase intra-union trade and
the symmetry of shocks. Yet Mundell’s paper, as the quote above makes clear, is not about
fixed exchange rates as such, but about fixed exchange rates combined with rigid wages
and prices. This second element has figured relatively little in subsequent discussion, no
doubt because the existence of these nominal rigidities is taken for granted.
JEL Classification numbers: E31, F31.
*The authors thank two anonymous referees, the editor, JonathanTemple and Mark Roberts for extremely helpful
comments on previous drafts. Anyer rors that remain are of course the authors’responsibility.
Price adjustment in currency unions 789
An important component of modern economic theory, the rational expectations as-
sumption, implies that nominal rigidities will not be entirely determined by the institutional
structure of labour and product markets; rather, they will be endogenous to macroeconomic
policy, and in particular to the exchange rate regime in place. Price-setters are likely to
behave differentlywhen faced with a government firmly committed to a fixed exchange rate
to how they would if the government were known to be willing to adjust the exchange rate
after prices have been set. If currency unions were to induce significantlyg reater wageand
price flexibility through the exchange rate commitment, that would reduce the employment
effects of region-specific shocks and absorb some of the pressure that would otherwise fall
on other adjustment mechanisms. In other words, the point about the endogeneity of the
optimum currency area criteria may also apply to wage and price rigidity. There has been
very little empirical work on this issue in general, although it has been an important element
of the discussion and analysis of the crisis in the euro area.
Recent history does not support the view that currency unions are immune from shocks
that require internal adjustment. In the euro area, for example, large capital flows from
the centre to the periphery collapsed after the global financial crisis, leaving internal real
exchange rates severelymisaligned (Jaumotte and Sodsriwiboon, 2010; Shambaugh, 2012).
If nominal rigidities obstruct the required internal price adjustment, the resulting output
losses may precipitate a flight from a country’s assets, particularly if the banking system
is also exposed to significant losses, as in the euro area.1In second-generation models of
currency crises (e.g. Obstfeld, 1996), a crisis can be precipitated if agents perceive that
there is a limit to the output cost that the authorities are willing to bear in defence of the
currency.The same can happen in a cur rency union, because a severe crisis is likely to put
the possibility of leaving the union and devaluing back on the political agenda.
The general perception of the Eurozone crisis is that adjustment in the periphery has
been far too slow to prevent large output losses (Eichengreen, Jung and Moch, 2014;
Gibson, Palivos and Tavlas, 2014; Honkapohja, 2014). Ireland may be the poster boy of
post-crisis adjustment, having achieved a substantial reduction in relative unit labour costs,
but it is regarded as very much the exception that proves the rule (Whelan, 2014; OECD,
2016).
This paper addresses the issue of adjustment within a currency union. If an individual
member country’s wages and prices get too high relative to those of the other members,
the situation can only be corrected by adjustment of relative wages and prices. This is the
question that is addressed here: is there more internal wage and price adjustment in currency
unions than under other exchange rate regimes, because of the disciplinary effect of the
fixed exchange rate? Perhaps surprisingly, there has been virtually no formal investigation
of this issue.
In a rational expectations model, as mentioned above and shown below, wage- and
price-setters should be more willing to adjust wages and prices under hard pegs, because
the nominal exchange rate is known to be fixed.The results of our empirical analysis show
that, under floating or soft pegs, adjustment works more or less exclusively through the
nominal exchange rate, and price adjustment is small. In currency unions, as the model
1For a model of the interaction between banking and currency crises, see Bleaney, Bougheas and Skamnelos
(2008).
©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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