Working Paper: NBER ID: w19588
Authors: David Cook; Michael B. Devereux
Abstract: Open economy macro theory says that when a country is subject to idiosyncratic macro shocks, it should have its own currency and a flexible exchange rate. But recently in many countries policy rates have been pushed down close to the lower bound, limiting the ability of policy-makers to accommodate shocks, even in open economies with flexible exchange rates. In this paper, we show that if the zero bound constraint is binding and policy lacks an effective `forward guidance' mechanism, a flexible exchange rate system may be inferior to a single currency area, even when there are country-specific macro shocks. When monetary policy is constrained by the zero bound, under independent currencies with flexible exchange rates, the exchange rate exacerbates the impact of shocks. Remarkably, this may hold true even if only a subset of countries are constrained by the zero bound, and other countries freely adjust their interest rates. In order for a regime of multiple currencies to dominate a single currency area in a liquidity trap environment, it is necessary to have effective forward guidance in monetary policy.
Keywords: Optimal Currency Area; Liquidity Trap; Monetary Policy; Exchange Rates
JEL Codes: F3; F33; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| zero bound constraint (D10) | exchange rate exacerbates impact of country-specific shocks (F31) |
| exchange rate exacerbates impact of country-specific shocks (F31) | relative real interest rate appreciation (E43) |
| exchange rate exacerbates impact of country-specific shocks (F31) | nominal and real exchange rate appreciation for affected country (F31) |
| liquidity trap environment (E41) | adjustment to country-specific shocks is more efficient in a single currency area (F36) |
| absence of independent currencies (F36) | prevents destabilizing exchange rate adjustments (F31) |
| absence of independent currencies (F36) | acts as a commitment mechanism for future inflation (E31) |
| optimal forward guidance (E61) | restores benefits of multiple currencies (F31) |