Optimum Currency Areas Under Inflation Targeting

Several countries face the choice between targeting inflation independently and entering a monetary union that targets inflation. The present paper extends the theory of optimum currency areas to deal with this choice. In contrast to the conventional theory, countries might form more of an optimum currency area the more asymmetric supply shocks are. By studying the stabilization properties of independent inflation targeting in contrast to inflation targeting within a monetary union, this paper extends the theory of optimum currency areas (OCA). Initiated by Mundell (1961), the theory has received increased attention in recent years, mainly because of the introduction of the Euro. In the literature, four relationships between the members of a potential OCA are highlighted:1 1) the similarity of shocks; 2) the extent of trade between the potential members; 3) the degree of labor mobility; and 4) the system of fiscal transfers. As regards the similarity of shocks, Mundell (1961) focused on demand shocks in his pioneering contribution. Asymmetric demand shocks were shown to weaken the case for a monetary union. In much of the subsequent literature on OCA, asymmetric shocks of any type have been taken as arguments against a monetary union. For instance, when discussing whether Europe is an optimum currency area, Bayoumi and Eichengreen (1993, p. 223) conclude that “. . . our finding that supply shocks are larger in magnitude and less correlated across regions in Europe than in the United States underscores the possibility that the European Community may find it more difficult, initially, to operate a monetary union than the United States.’’ In this paper, we show that when the choice is between targeting inflation independently and doing so within a monetary union, the presence of asymmetric 100 RØISLAND AND TORVIK supply shocks might in fact be an argument in favor of a union. As regards asymmetric demand shocks, it is the case also under inflation targeting that this is an argument against introducing a common currency. Among industrialized countries, explicit or implicit inflation targeting has become the principal guideline for monetary policy. This has lead to an increasing literature on various aspects of inflation targeting. Although most of the earlier theoretical literature on inflation targeting was limited to studying closed economies, increased attention is now being given to inflation targeting in open economies. Among the contributors are Rødseth (1996), Ball (1998), Batini and Haldane (1998), Svensson (2000), Galı́ and Monacelli (2000), and Clarida, Galı́, and Gertler (2001). Berger, Jensen, and Schelderup (2001) discuss the flexibility loss for a small open economy by pegging the exchange rate. Leitemo and Røisland (2003) compare inflation targeting and exchange rate targeting within an estimated model with a traded and a non-traded sector. Only a few papers consider inflation targeting within a multi-country framework. Persson and Tabellini (1996) consider Stage III of the EMU within a two-country framework with focus on the relationship between the “ins’’ and the “outs.’’ However, they do not consider entering a monetary union that targets inflation as an alternative to independent inflation targeting. In our view, this is the most relevant alternative to independent inflation targeting for many countries.2 Furthermore, Persson and Tabellini consider only supply shocks, while we distinguish between supply and demand shocks. This distinction will be shown to be of crucial importance for the differences in the stabilisation properties of various regimes. Canzoneri, Nolan, and Yates (1997) compare inflation targeting with the ERM in a two-country model, in which one of the countries (“Germany’’) has low inflation and an optimal degree of stabilization and the other country (“Great Britain’’) lacks the credibility to implement the optimal monetary policy rule. Their focus is on credibility rather than stabilization. Although not considering inflation targeting, another paper related to ours is Lane (2000), who considers the stabilization properties of a currency union versus alternative exchange rate regimes. Lane assumes that the Central Bank minimises a general loss function, and that welfare in alternative regimes is compared using the same loss function as that minimised by the Central Bank. In contrast to Lane we start out by following the approach of Persson and Tabellini (1996), Frankel and Chinn (1995), and others by assuming that the Central Bank must commit to a monetary policy target for credibility reasons. Moreover, the central issue in our paper is to derive implications with respect to optimum currency areas. By starting out studying strict inflation targeting the intuition behind our new results becomes clear. We then extend the approach to flexible inflation targeting, and show under which conditions the conclusions from the strict inflation targeting case also holds under this type of regime. The distinction between strict and flexible inflation targeting may be interpreted institutionally as the distinction between a hierarchical mandate for monetary policy where price stability is the primary objective, and a dual mandate where OPTIMUM CURRENCY AREAS UNDER INFLATION TARGETING 101 price and output stability are put on an equal footing. Laurence Meyer (2001), member of the Board of Governors of the US Federal Reserve System, argues that Central Banks with hierarchical mandates conduct inflation targeting in a stricter way and thereby accept higher output volatility than Central Banks with dual mandates. Cecchetti and Ehrmann (1999) provide some empirical support for this view. The paper is organized as follows: In Section 1 we set up the model. The alternative regimes under strict inflation targeting are discussed in Section 2, as are some new international transmission channels introduced by inflation targeting. Section 3 is devoted to the implications with respect to optimum currency areas. In Section 4 we extend our approach to allow for flexible inflation targeting. We show that the conclusions from the strict inflation targeting case might also hold under this type of regime, provided that the weight on output stabilization relative to inflation stabilization is sufficiently small. Section 5 concludes.