Comment on H. Robert Heller's "Exchange Rate Flexibility and Currency Areas"

F enkel, Jacob A. A icle Commen on H. Robe Helle 's "Exchange Ra e Flexibili y and Cu ency A eas" Zei sch i ü Wi scha s- und Sozialwissenscha en (ZWS) - Vie eljah essch i de Gesellscha ü Wi scha s- und Sozialwissenscha en, Ve ein ü Socialpoli ik P o ided in Coope a ion wi h: Duncke & Humblo , Be lin Sugges ed Ci a ion: F enkel, Jacob A. (1979) : Commen on H. Robe Helle 's "Exchange Ra e Flexibili y and Cu ency A eas", Zei sch i ü Wi scha s- und Sozialwissenscha en (ZWS) - Vie eljah essch i de Gesellscha ü Wi scha s- und Sozialwissenscha en, Ve ein ü Socialpoli ik, ISSN 0342-1783, Duncke & Humblo , Be lin, Vol. 99, Iss. 1-2, pp. 136-146, h ps://doi.o g/10.3790/schm.99.1-2.136 This Ve sion is a ailable a : h ps://hdl.handle.ne /10419/291430 S anda d-Nu zungsbedingungen: Die Dokumen e au EconS o dü en zu eigenen wissenscha lichen Zwecken und zum P i a geb auch gespeiche und kopie we den. Sie dü en die Dokumen e nich ü ö en liche ode komme zielle Zwecke e iel äl igen, ö en lich auss ellen, ö en lich zugänglich machen, e eiben ode ande wei ig nu zen. So e n die Ve asse die Dokumen e un e Open-Con en -Lizenzen (insbesonde e CC-Lizenzen) zu Ve ügung ges ell haben soll en, gel en abweichend on diesen Nu zungsbedingungen die in de do genann en Lizenz gewäh en Nu zungs ech e. Te ms o use: Documen s in EconS o may be sa ed and copied o you pe sonal and schola ly pu poses. You a e no o copy documen s o public o comme cial pu poses, o exhibi he documen s publicly, o make hem publicly a ailable on he in e ne , o o dis ibu e o o he wise use he documen s in public. I he documen s ha e been made a ailable unde an Open Con en Licence (especially C ea i e Commons Licences), you may exe cise u he usage igh s as speci ied in he indica ed licence. h ps://c ea i ecommons.o g/licenses/by/4.0/ Commen on H. Robe Helle 's "Exchange Ra e Flexibili y and Cu ency A eas" By Jacob A. F enkel* Robe Helle 's pape "Exchange Ra e Flexibili y and Cu ency A eas" is ex emely use ul in highligh ing he o mal analogy be ween ac o s ha a e ele an o he choice among al e na i e exchange a e sys ems and hose ha a e ele an o he de e mina ion o op imal cu ency a eas. Mo e impo an ly, Helle aces up o he di icul challenge o de ising an empi ical amewo k ha is use ul o e alua ion o coun ies' ac ual choice among al e na i e exchange a e sys ems. My ema ks a e di ided in o h ee pa s. The i s elabo a es on some heo e ical conside a ions conce ning he de e minan s o op imal cu - ency a eas. The second deals wi h he empi ical amewo k and he hi d p o ides a ske ch o an al e na i e app oach o he analysis o he op imal deg ee o exchange a e lexibili y. I. Op imal Cu ency A eas: Theo e ical Conside a ions The Second Amendmen o he A icles o Ag eemen o he In- e na ional Mone a y Fund p ac ically pe mi s each coun y o choose an exchange a e sys em ha is mos app op ia e o i s needs. Helle ecognizes, and his is his majo heo e ical insigh , ha he exis ing li e a u e on he de e minan s o op imal cu ency a eas may be ele an o analyzing he de e minan s o coun ies' choice among al e na i e exchange a e sys ems. This insigh is hen ollowed by a use ul su ey o he majo ac o s ha ha e been men ioned in he li e a u e on op imal cu ency a eas. These ac o s a e: (i) he deg ee o openness, (ii) he size o he economy, (iii) he deg ee o commodi y di e si ica ion, (i ) he deg ee o capi al ma ke in eg a ion, and ( ) he deg ee o simila i y o in la ion a es. Helle hen desc ibes he em- pi ical p oxies o hese ac o s which a e hen used in his empi ical s udy. In wha ollows I will elabo a e on hese measu es and ou line some o hei limi a ions. I should be emphasized a he ou se ha hese limi a ions should no be iewed as a c i icism o Helle 's con- * Depa men o Economics. Uni e si y o Chicago, 1126 Eas 59 h S ee , Chicago, Illinois 60637, USA. OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 Commen on H. Robe Helle 137 ibu ion. Helle , who is undoub edly awa e o hese limi a ions, has chosen o p o ide a ai h ul su ey o he exis ing li e a u e. Ac- co dingly, my commen s should be iewed in he b oade con ex o he li e a u e on op imal cu ency a eas. 1. The Deg ee o Openness Acco ding o he "openness" c i e ion economies wi h a la ge o eign ade sec o should p e e ixed exchange a es, while ela i ely "closed" economies, wi h a small o eign ade sec o , should p e e lexible exchange a es. The a gumen elies on he Keynesian ame- wo k in which p ices a e ixed and in which he adjus men mechanism is analyzed in e ms o he o eign ade mul iplie ha is in e sely ela ed o he p opensi y o impo . This amewo k has also been used in s udies o he demand o in e na ional ese es wi h he p edic ion ha ela i ely closed economies need mo e in e na ional ese es han economies ha a e ela i ely open. The majo cha ac- e is ics o he ixed-p ice model is ha all ex e nal imbalances a e elimina ed by adjus men s o na ional income ia he o eign ade mul iplie which is in e sely ela ed o he impo p opensi y. I can be shown, howe e , ha when ex e nal imbalances a e elimina ed by changes in he p ice le el and in ela i e p ices, he e ec o openness is no clea -cu and in ac , unde ce ain condi ions, i migh lead o conclusions ha a e opposi e o hose o he simple p iceless model.1 I is also a gued ha in ela i ely open economies changes in he exchange a e induce la ge changes in he p ice le el which may no be desi able. The e o e, i is a gued, ha mo e open economies would p e e ixed a es. In his con ex wo poin s a e no ewo hy. Fi s , i is impo an o ecognize ha a gi en shock has o be abso bed in one o m o ano he . The e o e, in o de o p o ide o a meaning ul com- pa ison o he implica ions o al e na i e exchange a e sys ems, one should speci y how shocks a e abso bed when he exchange a e is ixed. Second, in o de o be able o assess he app op ia eness o al e na i e exchange a e sys ems one should speci y he cause o exchange a e luc ua ions. In pa icula one should indica e whe he he shocks a e " eal" o mone a y, as well as whe he he shocks o igina e om domes ic o om o eign dis u bances. I will e u n o hese dis inc ions in Sec ion III below. 2. The Size o he Economy Acco ding o he size c i e ion, small economies will p e e ixed exchange a es and, he e o e, will ind i use ul o join a mone a y 1 Fo an ou line o he implica ions o he p ice adjus men model see F enkel (1974). OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 138 Jacob A. F enkel union. The basic a gumen unde lying his p oposi ion elies on he concep o op imal scale, acco ding o which he size o small coun ies is likely o be sub-op imal and he e o e, p o iding an incen i e o enla ge he e ec i e economic size by o ming a union. I is pe inen o no e, howe e , ha his c i e ion does no p o ide a guide o he undamen al ques ion o " o whom o peg". Mo eo e , i migh be use ul o speci y in g ea e de ail wha a e he " ixed ac o s" which gi e ise o diminishing e u ns and he eby imply he concep o op imal size. F om he iewpoin o he empi ical implemen a ion i migh be no ed ha since size is likely o be nega i ely co ela ed wi h openness (a e all, he la ges uni — he wo ld — is a closed economy), i migh be di icul o sepa a e he e ec o size om he e ec o openness. 3. The Deg ee o Commodi y Di e si ica ion Acco ding o he di e si ica ion c i e ion, coun ies wi h a high deg ee o commodi y di e si ica ion will p e e ixed a es and will he e o e join a mone a y union. The a gumen he e is ha highly di e si ied economies a e likely o ha e a di e si ied expo sec o which, in u n, is less likely o be subjec ed o la ge shocks since he a ious shocks will end o o se each o he . I is impo an o emphasize, howe e , ha he ele an a iables a e he deg ee o di e si ica ion o expo s as well as he deg ee o di e si ica ion o impo s. As an empi ical ma - e , coun ies' impo s end o be mo e di e si ied han expo s. Fu - he mo e, he ex en o which di e si ica ion p o ides a cushion agains shocks depends c i ically on whe he he a ious sec o al shocks a e independen , o whe he hey a e posi i ely o nega i ely co ela ed. 4. The Deg ee o Capi al Mobili y MundelVs o iginal con ibu ion o he li e a u e on op imal cu ency a eas emphasized he ole o capi al mobili y. Acco ding o he mobili y c i e ion coun ies be ween which he e is a high deg ee o ac o ma ke in eg a ion (e. g., a high deg ee o capi al mobili y) will p e e o ha e a ixed exchange a e by joining a mone a y union. In he absence o a good measu e o he deg ee o capi al mobili y, Helle chose o measu e i in e ms o he a io o comme cial banks' o eign asse s as a pe cen age o he money supply acco ding o which a high pe cen age indica es a high deg ee o capi al mobili y. Since Mundell's concep emphasizes he mobili y o capi al as a ac o o p oduc ion (i. e., mobili y o physical capi al), one wonde s how well i is ep esen ed by measu es o he mobili y o inancial capi al.2 Fu - OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 Commen on H. Robe Helle 139 he mo e, o measu ing he deg ee o inancial in eg a ion I would p e e o use a concep o "p ice in eg a ion" a he han ha o "quan i y in eg a ion". Thus, he deg ee o equali y o a es o e u n migh be a be e p oxy o in eg a ion han measu es which ela e o he dis ibu ion o owne ship o wo ld asse s. Needless o say, de ising a measu e o he deg ee o capi al mobili y is an ex emely di icul ask, and Helle should be complimen ed o a emp ing o p o ide such a quan i iable index. 5. The Deg ee o Simila i y o In la ion Ra es5 One o he mos impo an c i e ia emphasized by Helle is he deg ee o simila i y o in la ion a es acco ding o which coun ies wi h simila in la ion a es will end o p e e g ea e ixi y o exchange a es. Since a mone a y union esul s in an au oma ic ansmission o in la ion h oughou he in eg a ed domain, i seems easonable o a gue ha p ospec i e membe s o he union should posses simila as es conce n- ing he cou se o in la ion. Indeed, only when in la iona y p e e ences a e simila migh one expec so e eign s a es o elinquish mone a y independence o he bene i s o a mone a y union. F om he empi ical iewpoin , howe e , one aces he di icul ask o dis inguishing be ween cause and e ec . Do membe coun ies ha e simila a es o in la ion because hey ha e joined he union o ha e hey joined he union because o hei simila as es? I is use ul he e o e o examine in somewha g ea e de ail he ac o s which de e mine coun ies' p e e ence o in la ion. These p e e ences a e de e mined by a wide spec um o conside a- ions which include socio-psychological elemen s as well as conside a- ions ela ing o he e iciency o iscal managemen . To illus a e he o me , i is qui e clea ha cu en as e di - e ences be ween B i ain and Ge many e lec o some ex en he impac o di e en expe iences in he pas . Ge many's a i ude owa ds in la ion is p obably in luenced by Ge many's pas expe ience wi h he hype in la ion o he 1920's, while B i ain's a i ude owa ds unem- ploymen is p obably in luenced by he B i ish expe ience wi h unem- ploymen du ing he 1920's. F om his iewpoin hese wo coun ies do no seem o be po en ial candida es o a success ul union. 2 In p inciple, he e ec s o mobili y o physical capi al could be linked o he mobili y o inancial capi al h ough equali y o he a es o e u n since, in equilib ium, he a e o in e es should equal he a io o he en al on capi al o i s p ice. 3 The a gumen s in he ollowing wo sec ions a e adop ed om F enkel (1975). OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 140 Jacob A. F enkel Since mone a y policies wi hin he union mus be ha monized and coo dina ed, go e nmen s joining he union should ha e simila iews conce ning he op imal use o he in la ion ax as a means o col- lec ing e enue. The op imal use o an in la ion ax depends upon he na u e o he demand o money, he a e o g ow h o income, and mos impo an , on he use and e icacy o o he o ms o iscal axa ion and he p og essi i y o he ax b acke schedules. This sugges s ha candida es o a mone a y union should be simila in hose espec s, and ha he deg ee o iscal ha moniza ion would also igu e as one o he ele an c i e ia. 6. The Deg ee o O he Fo ms o In eg a ion One o he c i e ia ha is no analyzed by Helle is he e ec o exis ing o ms o economic in eg a ion (e. g., a common ma ke ) on he incen i es o ex end hese o ms so as o include also a mone a y in- eg a ion. Fo example, much has been w i en conce ning he p ospec s o a Eu opean mone a y in eg a ion as a sequel o he Eu opean com- mon ma ke . I is use ul, he e o e, o analyze he wisdom o p omo ing an in e na ional sys em which es s on he equi emen ha go e n- men s ha monize policies o e a b oad ange o economic issues. Conside o example he ela ionship be ween cus om unions and mone a y in eg a ion. The c i e ia o joining a cus om union di e s om hose ele an o joining a mone a y union. I is concei able ha in cases whe e joining a cus om union p o es o be bene icial (acco ding o he ade c ea ion- ade di e sion c i e ion), he c i e ia o he bene icial o ma ion o a mone a y union may no necessa ily be ul il- led. In ac , since exogenous dis u bances canno be p esumed o be pe ec ly co ela ed among he a ious coun ies, i migh be easonable o educe po en ial ic ions a ising om con lic s o in e es s by lea - ing each membe s a e wi h a deg ee o eedom o independen ly use some policy ins umen s in pu suing disc e iona y policies. Thus, a coun y joining a mone a y union migh wish o p ese e some in- dependence in comme cial policy while a coun y joining a cus om union migh wish o e ain some independence in mone a y policy. The abo e analysis also implies ha mone a y unions migh be bene icial o economies among which he e exis s a posi i e co ela ion o exogenous dis u bances, so ha expansiona y and con ac iona y po- licies would be mu ually consis en wi h he needs o all pa ne s. II. The Empi ical F amewo k Helle 1 s empi ical amewo k is bo h o iginal and imagina i e. He employs a disc iminan analysis in o de o classi y coun ies in o OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 Commen on H. Robe Helle 141 ce ain g oups. He is hus able o iden i y and quan i y he impo ance o he a ious cha ac e is ics (size, openness, e c.) common o he g oup o coun ies which ha e chosen o peg hei exchange a e and hose common o coun ies which ha e chosen o le hei exchange a e loa . Basically, his app oach di ides coun ies in o g oups (pegge s and loa e s) such ha he combined a iance o he a ious cha ac e is ics (size, in la ion, e c.) wi hin he g oup is minimized, while he combined a iance be ween he g oups is maximized. Implici ly, i is assumed ha he a ious cha ac e is ics a e independ- en o he choice o he exchange a e sys em, and hus, ha hey may indeed be iewed as cha ac e is ics o he coun y in ques ion. Fo some o he cha ac e is ics (like size and openness) his assump ion seems alid. Fo o he s, one may wonde o wha ex en a e he cha ac e is ics hemsel es in luenced by he choice o he exchange a e sys em. Fo example, o wha ex en a e he a es o in la ion o he deg ee o capi al ma ke in eg a ion a ec ed by he exchange a e sys em? As o he choice o cha ac e is ics, my p e ious discussion has al- eady indica ed he desi abili y o ex ending he lis so as o include a a iable ha cha ac e izes he iscal s uc u e o he coun ies in ques- ion. Helle 1 s con ibu ion in he empi ical sec ion is in unco e ing some impo an empi ical egula i ies. He hus aces up o he di icul chal- lenge o con on ing he a ious insigh s o heo y agains empi ical ac s. I iew he s udy as a con ibu ion o posi i e analysis. Cau ion should be exe cised in using he conclusions o no ma i e p esc ip- ions. Helle was able o p o ide us wi h a lis o cha ac e is ics ha a e common o he majo i y o coun ies ha ha e chosen o peg hei exchange a e as well as a lis o cha ac e is ics ha a e common o he majo i y o coun ies which chose o ha e g ea e lexibili y o ex- change a es. As o he no ma i e ques ion, i seems ha mo e esea ch is needed o de e mine wha exchange a e sys em is app op ia e o each coun y. III. A Ske ch o an Al e na i e App oach4 Helle *s obse a ion ha he In e na ional Mone a y Fund pe mi s coun ies o choose among a ela i ely b oad spec um o exchange a e sys ems is impo an . Acco ding o e ised A icle IV, coun ies may choose among a ious deg ees and o ms o ixi y o exchange a es. In p ac ice, coun ies indeed ha e chosen o manage hei exchange a es 4 I am indeb ed o Michael Bazda ich o esea ch assis ance and sugges - ions conce ning he ma e ial in his sec ion. OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 142 Jacob A. F enkel in one o m o ano he . In wha ollows I will ske ch a simple analy ical amewo k ha highligh s some o he de e minan s o he op imal deg ee o exchange a e lexibili y. The analysis will emphasize he ole o he s ochas ic s uc u e o he a ious shocks which a ec he economy, and i s pu pose is o sugges an addi ional se o cha ac- e is ics which migh be included in Helle 's disc iminan analysis. Conside a small economy ha is subjec o wo ypes o epe i i e and se ially unco ola ed shocks. These shocks, which a e speci ied below, a e e e ed o as eal and mone a y shocks. Deno e he supply o ou pu by Y and le (1) Y = yen; oj) whe e ¡i is a s ochas ic shock ( he " eal" shock) wi h a cons an a iance a*. The mean o he dis ibu ion o he eal shock is chosen o be — 0^/2 so as o assu e ha he expec ed alue o ou pu equals y (pe - manen income). The second shock a ises om he mone a y sec o . Le he demand o nominal cash balances L be (2) L = kP Y e* ; e~N (- o2j2y whe e k deno es he desi ed money-income a io, P deno es he domes ic p ice le el and e deno es he s ochas ic shock o he demand o money ( he "mone a y" shock). The domes ic p ice le el is linked o he o eign p ice h ough he pu chasing powe pa i y ela ionship. Thus (3) P = S P* whe e P? deno es he o eign p ice le el and S deno es he exchange a e ( he p ice o o eign cu ency in e ms o domes ic cu ency). To simpli y he analysis i is assumed ha o eign p ices a e ixed (and hus will be deno ed hence o h as P*), ha pu chasing powe pa i y holds de e minis ically and ha x and e a e independen .5 Assume ha he low demand o money A Md co esponds o a s ock adjus men p ocess such ha (4) A Md = & (L - M ) whe e M deno es he money s ock a he beginning o he pe iod. 5 The implica ions o elaxing some o hese assump ions a e analyzed in F enkel (1976). OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13 Commen on H. Robe Helle 143 Using equa ions (1) and (3) we may exp ess he demand o money (2) as (5) L = kS P*ye * + * . When he exchange a e is lexible, i will adjus so as o elimina e any s ock disequilib ium in he money ma ke , hus ensu ing ha L — M = 0. Using (5) i ollows ha when he exchange a e is lexi- ble, (6) kS F* ye/*** - M = 0 . The equilib ium exchange a e can be w i en as (7) S = (M /kP* y)e-(? + ') and he pe cen age change he eo is (8) In S - In S _ = In (M ikS _1P* y) - Q* + s) . The o he ex eme sys em is he ixed exchange a e sys em o which (9) InSj — In= 0 . Using (8) and (9) we may de ine an index y such ha 0 < y < 1: (10) y = (In S - In S _ ¿/[In (M /kS . P* y) - (p + e)] . The coe icien y cha ac e izes he whole spec um o exchange a e egimes. When y = 0, he sys em is ha o a ixed exchange a e, and when y = 1 he sys em is ha o a eely lexible exchange a e. An in e media e alue o y indica es an in e media e deg ee o exchange a e lexibili y. We will e e o he coe icien y as he coe icien o managed loa , o he in e en ion index. F om he policy pe spec i e, he basic ques ion is o de e mine he op imal alue o y, ha is, o de e mine he op imal deg ee o exchange a e lexibili y. In p inciple, i shocks we e iden i iable, he op imal policy would be o allow he exchange a e o co ec mone a y dis u bances bu no eal dis u bances.6 We will assume, howe e , ha in o ma ion is in- comple e and ha du ing a gi en pe iod only he join ou come o he shocks [JL + s is known bu no he sepa a e alues o ¡J, and s. I is his lack o comple e in o ma ion which necessi a es a second-bes policy.7 6 Fo an analysis o his p oposi ion see Fische (1977). 7 The assump ion o he lack o comple e in o ma ion has been used by G ay (1976) o analyze pa ial wage indexa ion. OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/schm.99.1-2.136 | Gene a ed on 2023-04-04 11:56:13