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

The theory of optimal currency areas, due to Mundell and McKinnon, has enjoyed a revival of interest in the wake of European discussions of monetary union. The basic theme of this old literature is that there are potential gains for stabilization policy in an independent exchange rate and money because rigidity of prices causes an inadequate response of relative prices to shocks. This theme has been taken up recently in empirical work on fixed versus floating exchange rates. This paper examines whether there is support for it in the microfoundations of linked open economies. It uses the cash-in-advance general equilibrium approach of Lucas, following along the lines of Canzoneri and Diba, but focuses on instability and its costs rather than optimal transformation ratios. It finds support for the insights of the optimal currency area literature. The result comes from the cash-in-advance constraint, which causes labour supply to respond to expected inflation (and so money growth) between this and the next period: the household faces an inevitable delay between working (receiving cash) and being able to spend the proceeds. This delay is the microfoundation analogue of the `nominal (price) rigidity' in the optimal currency area models. Though the direction of money supply responses is orthodox (counter-cyclical), however, it is not clear whether it stabilizes prices (though it probably stabilizes output). By contrast, in the empirical work stability has been gauged by the variance of output and prices. Hence this microfoundations model, though in a way supporting the optimal currency area literature, does not mimic what that literature regards as `the real world'.