Exchange Rate Economics: Theories and Evidence by Ronald MacDonald

By Ronald MacDonald

First released in 2007. Routledge is an imprint of Taylor & Francis, an informa corporation.

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Example text

A second advantage of fixed rates is that when exchange rates are flexible they are, as we have noted, highly volatile and such volatility can impart uncertainty into trade and investment decisions, thereby having a negative influence on international trade and investment. Removing this source of uncertainty should therefore encourage international trade and investment. However, an alternative response is to say that trade and investment should be unaffected since agents can hedge the risk in the foreign exchange market.

Frankel and Rose (1998) examined the interrelationship between two optimum currency area criteria: the amount of bilateral trade integration and business cycle correlation. 20 However, there is another dimension to this argument that relates to sectoral specialisation: if sector specific demand and supply shocks are an important component of macroeconomic fluctuations (business cycles) then regions with similar sectoral structures will have relatively symmetric business cycles (Kenen 1963; Barrios et al.

Indeed, from our discussions in the previous section there would be a clear advantage to having a single currency. So the issue of joining a monetary union comes down to the question of whether shocks are symmetric or asymmetric. This was the basic insight of Mundell’s (1961) seminal paper. If the shocks hitting regions A and B are in fact asymmetric, at least in part, are there any factors which would substitute for the lack of an independent monetary policy if the two regions decided to participate in a monetary union?

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