On the relevance of exchange rate regimes for stabilization policy

On the Relevance of Exchange Rate Regimes for Stabilization Policy This paper assesses the relevance of the exchange rate regime for stabilization policy. This regime question cannot be dealt with independently of other institutions, in particular how fiscal policy is designed. We show that once fiscal policy is taken into account, the exchange rate regime is irrelevant. This is the case independently of the severity of price rigidities, independently of asymmetries across countries in shocks and transmission mechanisms and regardless of the incompleteness of international financial markets. The only relevant condition is labour mobility. The immobility of labour across countries is a necessary condition for our results. JEL Classification: E31, E63, F20, F33, F41 and F42 Keywords: fiscal and monetary policy, fixed exchange rates, labour mobility, monetary union, nominal rigidities and stabilization policy Bernardino Adao Research Department Banco de Portugal Av Almirante Reis 71 1150 Lisboa PORTUGAL Email: [email protected] For further Discussion Papers by this author see: www.cepr.org/pubs/new-dps/dplist.asp?authorid=140367 Isabel Correia Departmento de Estudos Económicos, Banco de Portugal R. Francisco Ribeiro P-1100 Lisboa PORTUGAL Email: [email protected] For further Discussion Papers by this author see: www.cepr.org/pubs/new-dps/dplist.asp?authorid=115639 Pedro Teles Departmento de Estudos Económicos, Banco de Portugal R. Francisco Ribeiro P-1100 Lisboa PORTUGAL Email: [email protected] For further Discussion Papers by this author see: www.cepr.org/pubs/new-dps/dplist.asp?authorid=115738 Submitted 25 July 2006 I. Introduction This paper revisits the issues in the optimal currency area literature, as in Mundell (1961) and a more recent literature, on the optimal choice of an exchange rate regime. What are the costs of a …xed exchange rate regime when there is a role for stabilization policy? We address this question allowing for heterogeneity in the shocks and the response to them, restrictions on the mobility of factors and incompleteness of asset markets, as is standard in the optimal currency area literature. The main di¤erence of our approach is that we take into account that …scal instruments may be used fully for stabilization policy, in the absence of independent monetary. When di¤erent shocks hit di¤erent countries or when there are di¤erences across countries in the e¤ects of shocks, monetary policy, that has a stabilization role because of some form of nominal rigidity, may have to react di¤erently in the di¤erent countries. Because of this heterogeneity it is common to infer that there are costs of coordinating monetary policies, either through a …xed exchange rate regime or a monetary union. In the literature, these costs are taken to be higher the stronger are the asymmetries, the more severe are the nominal rigidities, the more pronounced is the incompleteness of international asset markets, the less mobile is labor, and, …nally, the less able is …scal policy in e¤ectively stabilizing the national economies (Corsetti, 2005). We show that when both …scal and monetary policies are considered jointly with the same ‡exibility in response to shocks, the loss of the country speci…c monetary tool is of no cost. This is true irrespective of the asymmetry in shocks or response to these and the severity of the nominal rigidities. The elements that are crucial in assessing the costs of a single monetary policy are the two last ones in the list by Corsetti above, but labor mobility works in the opposite way to the conventional wisdom. Fiscal and monetary policy are able to eliminate the costs of a monetary union only if labor is not mobile across countries. We consider a standard two country model. Each country specializes in the production of a composite tradeable good, which aggregates a continuum of goods produced using labor only. Labor is not mobile across countries. Money is used for transactions according to a cash-in-advance constraint on the purchases of the two composite goods by the households of each country. The government of each country must …nance exogenous expenditures on the good produced at home with distortionary taxes and seigniorage. The tax instruments are standard state-contingent labor income and consumption taxes. There is state-contingent private debt inside each country in zero net supply and noncontingent nominal public debt in each currency that can be traded internationally. We start by analyzing a benchmark economy where prices are ‡exible (sections 2 and 3). We show, in Section 3, that any equilibrium allocation in the ‡exible price, ‡exible exchange rates, economy can be implemented with …scal and monetary policies that induce stable producer prices and …xed exchange rates. This result has implications for economies with nominal rigidities and …xed exchange rates (Section 4). For those policies, that under ‡exible prices keep prices constant, if …rms were restricted in the setting of prices such as in Calvo (1983), those restrictions would be irrelevant and the same allocations could still be implemented. It follows that under sticky prices and …xed exchange rates it is always possible to achieve the same allocations as when prices are ‡exible and exchange rates are also ‡exible. Under sticky prices there are allocations other than the ones achieved under ‡exible prices. It could still be the case that the allocation with the highest welfare would be amongst these. We show that this is not the case. Independently of the exchange rate regime, for each allocation that can be implemented under sticky prices there is one under ‡exible prices that can potentially improve welfare in both countries. The reason for this is that in order for sticky prices to be