Optimal Currency Areas
Microfoundations

Discussions of monetary union have revived interest in the theory of optimal currency areas, which has been taken up recently in empirical work on fixed versus floating exchange rates. In Discussion Paper No. 757, Research Fellow Patrick Minford examines whether there is support for this approach in the microfoundations of linked open economies. He uses a cash-in-advance general equilibrium approach that focuses on instability and its costs rather than optimal transformation ratios. The representative household maximizes utility over domestic and foreign goods and leisure, using income earned in the previous period to acquire goods in the current period; there are (perishable) goods, money, physical capital and foreign exchange markets. Under floating rates, money supply can be determined by the home government; optimal monetary policy induces households to take more leisure when there is a boom and less in a slump. Under fixed rates, foreign monetary policy applies and households' welfare will in general fall compared with floating, unless the foreign agent's preferences match the home agent's.

Minford argues that there are microeconomic foundations for the advantages that the optimal currency area literature claims for floating rates and independent monetary policy. These result from the cash-in-advance constraint, which causes labour supply to respond to expected inflation between this and the next period. Despite the orthodox direction of money supply responses, however, it is unclear whether they stabilize prices; in the empirical work stability has been gauged by the variance of output and prices. Furthermore, the difference between fixed and floating rates in this model relies entirely on the presence of activist monetary policy, whereas floating rates in optimal currency area models are potentially helpful even with fixed money supplies, so the microfoundations model does not mimic `the real world'.

Other People's Money: The Microfoundations of Optimal Currency Areas
Patrick Minford

Discussion Paper No. 757, January 1993 (IM)