Exchange Rate Policy: The euro area, the US, and Asia

Transcription

1 Exchange Rae Polcy: The euro area, he, and Leonor Counho Unversy of Cyprus, Economcs Deparmen June, 2009 Absrac Ths paper uses a hree-counry model of he, he euro area and, o analyze alernave polcy responses n he euro area o a currency apprecaon. The nal shock s an exogenous deprecaon of he dollar, followng whch he n auhores ry o manan her pares wh he dollar, whle he moneary auhory n he euro area can eher choose o keep s moneary polcy unchanged or ry o sablze s exchange rae. We analyze he condons under whch one opon s more aracve han he oher by carryng ou smulaons. We fnd ha n many cases s no opmal for he ECB o ry o offse euro apprecaon. I all depends on he degree of subsuably beween, euro area, and n goods, and he degree of compeon whn each marke. JEL Classfcaon: F4, E52 Keywords: New open economy macroeconomcs, beggar-hy-neghbour, exchange rae polcy, moneary polcy I am graeful o Danel Gros for useful commens and suggesons and o he parcpans of he Cenre for European Polcy Sudes (CEPS Macroeconomc Polcy Group meengs. I am also graeful o wo anonymous referees for valuable commens. The vews expressed here and any remanng errors are mne solely. Conac Informaon: (Tel; Leonor@ucy.ac.cy (Emal; Deparmen of Economcs, Unversy of Cyprus, P.O. Box 20537, CY-678 Ncosa, Cyprus (Malng address.

2 . Inroducon The sgnfcan deprecaon of he dollar beween 2002 and 2008, and he relucance of n counres o allow her currences o floa freely, coupled wh he ncreasng role of n he world economy, have srred he debae among polcymakers abou wheher he ECB should pursue polces o sablze and cural a rse n he euro. From 2002 o 2008 he euro seadly ganed n value agans he dollar n boh nomnal and real erms (see Fgure. Whle mos economss defended hs as a necessary adjusmen n he face of he large curren accoun defc, whch reached abou 6 percen of gross domesc produc n 2008 (see for nsance, Obsfeld and Rogoff, 2005, Devereux and Genberg, 2007, Lane and Mles-Ferre, 2007, Mussa, 2007, Clarda, 2007, and references heren, polcymakers and publc opnon n general expressed concern ha hese developmens were dermenal o Europe, and should be avoded n he fuure, especally snce he man counerpar of he defc has no been n he EU bu n. Fgure : Euro-dollar exchange rae Euros per dollar (lef scale Euro real effecve exchange rae (rgh scale Source: European Commsson, AMECO daabase. The values for 2009 are February 2009 s forecass for he year. Ths ssue has parcular mporance, because epsodes of concered polcal pressure on 2

3 he ECB could hreaen he ECB s ndependence. In 2007, for example, he ECB was under srong polcal pressure (albe no concered o cural he euro rse (see Fnancal Tmes, 2007, for nsance. Bu s an apprecaon of he euro really dermenal o he euro area, and do n polces nflc a larger burden on he euro area? Ths paper uses a smple racable model o analyze condons under whch condons a deprecaon of he dollar, gven he n peg, can be dermenal o he euro area. In he radonal framework of nernaonal economcs, he Mundell-Flemng-Dornsbush (MFD framework, he answer o he queson of wheher he deprecaon of he dollar s dermenal o he euro area would mos probably be yes. In he radonal analyss deprecaon n one counry s beggar-hy-neghbour because lowers he prce of home goods relave o foregn goods and, herefore, shfs rade away from foregn goods no home goods. More recenly, a "new open economy macroeconomcs" (NOEM, based on mcrofoundaons and usng he consumers welfare funcon as he bass for polcy evaluaon, has progressvely been replacng he MDF model n he analyss of he effecs of alernave macroeconomc polces (Obsfeld and Rogoff, 995 and Woodford and Roemberg, 997, were wo nfluenal conrbuons owards hs rend. Whn he new framework many compeng effecs are balanced n order for judgmen o be made of he overall mpac of macroeconomc polcy. In parcular, n he case of a deprecaon of he home currency s sll rue ha he prces of goods produced by he home counry become more compeve n he world marke (f goods are prced n he producer's currency, bu o he exen ha he deprecaon corresponds o a loosenng of moneary polcy n he home counry, and an ncrease n world demand, can sll be benefcal o he foregn counry. In addon, he erms of rade mprove n he foregn counry, ncreasng he purchasng power of foregn consumers. Overall, he srucural parameers of he model wll deermne whch effec domnaes. 2 Ths research s more closely relaed o he work of Lane and Mles-Ferre (2007, who underake smulaons usng he IMF's Global Economc Model (GEM, o analyze he 2 Bergn (2006 dscusses how well NOEM models f he daa n erms of exchange rae and curren accoun dynamcs, concludng ha hese models perform reasonably well, even hough ceran exensons may be warraned. 3

4 mpac of he adjusmens needed o brng he curren accoun back no balance, under dfferen adjusmen scenaros: ( a scenaro where adjusmen akes place gradually hrough an ncrease n he prvae savngs rae (he bengn scenaro; ( a scenaro where here s a sharp reversal of preferences for dollar asses, abandonmen of he n peg, and proecons measures worldwde (he dsrupve scenaro; and ( a scenaro where ncreased exchange rae flexbly s combned wh measures o boos consumpon n, srucural reforms n he euro area and Japan, leadng o faser growh n hese counres, and hgher nvesmen n ol exporng counres (he polces scenaro. They conclude ha srucural polces n Europe can help mgae he mpac of he adjusmen, and ha flexble exchange raes n do mply a smaller real exchange rae apprecaon n he euro area. In our analyss we focus on a dfferen ssue, however. Here, we nend o hghlgh he rade-off beween compeveness and he erms of rade effec, n an analycally racable model, and analyze dfferen polcy opons for he euro area, akng he polces of oher counres as gven. In hs analyss we use a hree-counry NOEM model o analyze alernave polcy responses of he moneary auhory n he euro area o a deprecaon of he dollar, assumng ha he n auhores peg her currences o he dollar. For smplcy, he model bundles he and he euro area no an area called he, so ha mos of he analyss resembles a wo-counry se up. In addon, assumes monopolsc compeon and prce rgdy, whch are he sandard assumpons n NOEM. 3 The shock ha wll be consdered s an exogenous deprecaon of he dollar, accommodaed by a moneary expanson. The n auhores ry o manan her pares wh he dollar, whle he moneary auhory n he euro area, he European Cenral Bank (ECB, can follow one of wo possble polcy alernaves: bengn neglec ; or ry o nervene o sablze s exchange rae. Our model follows closely he Cenre-Perphery model of Corse e al. (2000, bu s used o analyze a dfferen queson, and relaxes some of her resrcons (Corse e al., 2000, analyze he condons under whch one radng parner would have ncenves o abandon a peg n response o anoher radng parner s devaluaon. 3 The model wll be closely relaed o he model of Corse e al. (

5 Applyng he model o he case of hree moneary areas, he euro area, he, and, whch we wll defne as regons, we can observe ha a dollar deprecaon (accommodaed by a moneary expanson, has an ambguous effec on he euro area's welfare: frs, mproves he euro area's erms of rade; second, shfs overall rade away from n goods no ern goods ( and euro area producs; hrd, whn ern goods shfs rade away from euro area goods no goods. The frs wo effecs are posve, whle he hrd effec s negave. In addon, a moneary expanson by he ECB o cural euro apprecaon also has an ambguous effec on he euro area economy: worsens he euro area's erms-of-rade relave o he oher currency blocks (negave effec, shfs demand from n goods o ern goods (posve effec and, whn he (he euro area and he, shfs demand away from goods no euro area goods (posve effec. Only he n expanson has an unambguously posve effec on he euro area's welfare, provded ha he degree of compeon whn regons s hgher han he degree of compeon across regons (an assumpon ha s plausble. The srengh of he n response, however, wll depend on he ECB s polcy response, snce he exchange rae of n currences agans he depends on euro area moneary polcy. The degree of n expanson wll be larger when he ECB nervenes f here s more compeon beween and European goods han beween n and ern goods. Ths occurs because n ha case a moneary expanson by he euro area pus pressure on he n currences o apprecae; hence, he n auhores need a sronger response n order o defend her exchange rae. In order o analyze he choces of he ECB we smulae he welfare resuls for dfferen values of he parameers of neres. The smulaons show ha when he degree of compeon s hgh whn he regon, relave o he degree of compeon faces abroad, he erms of rade effecs domnae and he mpac of a euro apprecaon on he euro area's welfare s posve. In addon, he smulaons confrm ha he n peg always has a posve mpac on welfare n he euro area, f compeon whn regons s sronger han across regons. Alhough he peg offses he shf from n goods owards ern goods, expands world consumpon and mproves he euro area's erms of rade wh. The laer effecs are always more mporan han he frs when he degree of compeon whn he euro area s relavely large compared o he degree of 5

6 compeon beween euro area and. The gans from he n peg ncrease, he larger s share n he world economy. Fnally, he resuls show ha, for relavely low degrees of subsuon beween goods produced n dfferen counres he mpac of a moneary expanson by he ECB (and deprecaon of he euro wll be negave, bu producng a deprecaon becomes more aracve for he ECB he larger he subsuably beween euro area and foregn goods. 2. The model The model used for he smulaons follows Corse e al. (2000. We assume ha he world economy s formed of hree moneary areas whch wll be called regons: he, he euro area (or, and. 4 For smplcy, each regon specalzes n he producon of one ype of good, bu here s a ceran degree of subsuably beween hese goods. In addon, each regon produces a connuum of brands for s good, mperfecly subsuable beween each oher. Households n each regon decde how much o consume and work, and he quany of money balances o hold, by maxmzng an neremporal uly funcon subjec o an neremporal budge consran. The governmen collecs lump-sum axes from households and redsrbues hose n he form of ransfers. Segnorage revenues obaned by he cenral bank are also rebaed o he publc. The deals of he model are shown n he Appendx. For smplcy we assume ha he populaon share of each regon n he world economy s consan, and we bundle he and he euro area no an area called he. Ths allows he reducon of mos of he analyss o a wo-counry case. We defne as he share of he populaon n he (he euro area and he, whle he populaon share of s (. The 's share can be spl beween he ( and he euro area (. Hence, he populaon share of he n he world s gven by, whle he European share s (. In addon, he elascy of subsuon beween he goods produced n he and n goods wll be equal o ρ, whle he elascy of subsuon beween ern goods wll be referred o as ψ. 44 The regons wll be reaed n he same way as ndvdual counres hroughou he analyss. 6

7 The elascy of subsuon across brands n any regon wll be equal o. The household maxmzaon problem yelds he followng equlbrum relaonshps: ( an Euler equaon; a money demand equaon (2; and a consumpon-effor rade-off equaon (3: M P C C + + χ C P P C ( + C + ( + + E+ ( + E E + + ( (2 P, P k C Y (3 where household, C s he consumpon baske, Y s he oupu of he good produced by M denoes money holdngs denomnaed n he currency of regon, P s he un prce of he consumpon baske n currency, (+ + s he gross nomnal neres rae from perod o +, and he currency of counry ( E. A rse n and an apprecaon of he dollar. E denoes he prce of dollars n erms of E denoes a deprecaon of currency I s assumed ha prces ake one perod o adjus. A he me of a shock (he shor run producers are wllng o accommodae ncreases n demand a gven prces (assumng prces reman above margnal coss, so ha condon (3 only holds n he long run (when prces fully adjus o her equlbrum level. Prces are assumed o be predeermned n erms of he seller s currency. In hs model, counry 's curren accoun equaon wll be gven by equaon (4, whch smply saes ha he counry s ne clams from he res of he world (lef hand sde mus equal domesc ncome mnus absorpon (he rgh sde: E ( B B E B + P Y P C +, (4 The model can hen be lnearzed around a symmerc seady sae, where 7

8 B B B B 0 and agens do no expec any change n moneary polcy. 5 We assume a balanced-budge seady sae for smplcy, and we herefore gnore valuaon effecs, however, n he case of he euro area hese valuaon effecs are lkely o be nsgnfcan, snce, as menoned earler, he larges counerpar of he curren accoun defc s n (see Lane and Mles-Ferre, Sarng from such equlbrum we hen characerze he mpac of permanen unancpaed deprecaon of he dollar, when he n counres defend he value of her currences agans he dollar. 3. dollar deprecaon and he n peg The shock we wll analyze wh hs model wll be a deprecaon of he dollar, accommodaed by he money supply, such ha m µ. n auhores wll be assumed o arge he dollar; hence he response of he n auhores o dollar deprecaon wll be o defend her exchange rae hrough an expansonary moneary polcy. How much has o devalue, however, wll depend on he response of he euro area, due o hrd currency effecs. To see hs, noce ha n hs model he n currency s exchange rae agans he dollar can be wren as follows (see he calculaons n he Appendx: e ( ρ, ψ m Γ(, ρ ψ m + Π( ρ Ω,, m (5 where Ω (, ρ, ψ and ( ρ Π are always posve, and declnng wh he degree of subsuably beween n and ern goods (ρ, and and European goods (ψ n he case of Ω. (, ρ, ψ Γ on he oher hand s posve f ψ> ρ, bu negave oherwse. A moneary expanson n he euro area, and hence a deprecaon of he euro, 5 Subscrps and superscrps are used o denoe euro area varables. 6 Valuaon effecs also mean ha he dollar may no need o devalue much furher o correc he curren accoun mbalance, snce he apprecaon of he euro ranslaes no capal gans on euro denomnaed asses held n he, whch auomacally mprove he curren accoun (see Gournchas and Rey, 2005, 2007, bu Obsfeld and Rogoff (2005 show ha even akng no accoun valuaon effecs here s a need for subsanal deprecaon of he dollar o close even jus half of he curren mbalance. 8

9 has wo effecs of oppose drecon on he n exchange rae agans he dollar n hs model. Through nra- rade a moneary expanson n he euro area causes pressure on he dollar o apprecae and, ndrecly, he n exchange rae agans he dollar should deprecae. On he oher hand, hrough n- rade, a moneary expanson n he euro area pus pressure on he n exchange rae o apprecae. Accordng o equaon (5, n order o preserve he value of her currency he n auhores wll have o follow he followng moneary rule: m Ω ( ρ,, ψ Π( ρ m Γ + ( ρ,, ψ Π( ρ I s clear now ha he sze of he n expanson wll depend on he response by he euro area auhores. m (6 4. Alernave responses by he euro area 4. Welfare To gude he dscusson, hs secon explans he welfare mplcaons of he model. Because prces ake one perod o adjus, he seady sae akes one perod o be reached, and he model s reduced o a wo-perod model: he shor run, and he long run. Solvng he model n erms of moneary expansons wll gve he followng resuls for welfare (n presen value erms n he : u [( ( Λ( ρ ( ρ m + ( ( + Λ( ρ ( ρ m ] where Λ(ρ s a posve bu declnng funcon of he degree of compeon beween and he (ρ. Accordng o equaon (7, when compeon whn regons s hgher han beween n and ern goods ( > ρ, a moneary expanson n s (7 9

10 always welfare mprovng for he as a whole, bu he effec of a moneary expanson n he on 's welfare s unceran. If he elascy of subsuon beween varees ( s very large, for nsance, so ha he economy s already close o he compeve equlbrum, he effec of a domesc moneary expanson s lkely o be negave; he negave erms of he rade effec wll domnae. 7 The same negave effec can occur f he elascy of subsuon beween ern and n (ρ goods s small. I s also possble o use he model o calculae he mpac of moneary expansons on he euro area s welfare, by unbundlng he. Ths s gven by equaon (8: where α α α 2 3 u α m + α 2 m α 3 + (( ( Λ( ρ ( ρ + Λ( ψ ( ψ ( ( ( Λ( ρ ( ρ Λ( ψ ( ψ ( ( + Λ( ρ ( ρ m (8 and Λ(ψ s a posve bu declnng funcon of he degree of compeon beween he euro area and he (ψ. The sgn of he parameer α 3 s always posve when > ρ, ha s, when he degree of compeon whn regons s sronger han he degree of compeon beween and he. In hs case, an n moneary expanson has an unambguously posve effec on he euro area's welfare. The sgns of he parameers α and α 2 depend on he values of he srucural parameers, ha s, a moneary expanson eher by he or by he ECB have boh posve and negave effecs on welfare n he euro area and a pror s dffcul o say whch effec domnaes. The posve effecs of a expanson are he ncrease n world demand, he mprovemen of he euro area's erms of rade, and he shfng of overall rade away from n goods no ern goods. In hs model he euro area's erms of rade mprove followng a deprecaon of he dollar because goods are prced n he currency of he producer. Obsfeld and Rogoff (2000 show ha here s sgnfcan emprcal evdence of a posve 7 See also Tlle (200 on he role of consumpon subsuably n he nernaonal ransmsson of moneary shock. 0

11 relaonshp beween a counry's erms-of-rade (measured as he rao of he prce of expors o he prce of mpors and he value of s currency. The negave effec of he expanson s he shfng of rade away from euro area goods no goods. Smlarly, he posve effecs of a moneary expanson n he euro area are an ncrease n world demand, and he shfng of rade away from n goods no ern goods and, whn ern rade, away from goods no euro area goods. The negave effec s a deeroraon of he euro area's erms of rade. 4.2 Bengn Neglec n he euro area In hs polcy scenaro he ECB chooses no o respond o exchange rae developmens, herefore m BN 0. I follows from equaon (6 ha he response n wll be gven by: m BN Π ( ρ + ( Π( ψ Π( ρ where Π(ψ s a posve bu declnng funcon of he elascy of subsuon beween euro area and goods (ψ, equvalen o Π(ρ when we subsue ρ by ψ. Hence ψ>π mples ha Π(ρ>Π(ψ and vce versa (see he Appendx for deals. µ (9 Subsung equaon (9 no he welfare funcon (8 yelds: u BN ( ρ + ( Π( ψ Π( ρ Π α µ + α 3 µ (0 In hs case here are only wo effecs on he euro area's welfare: he effec from he expanson (ambguous and he mpac from he n moneary expanson. 4.3 Inervenon o sablze he exchange rae Under hs scenaro, he ECB nervenes o sablze he euro exchange rae, such ha e 0. For ha a moneary expanson s requred, such ha:

12 m EST µ Subsung hs no equaon (9 gves he response of under hs regme: Noce ha when ( ρ + ( Π( ψ Π( ρ Π m EST µ + ( Π ( ρ Π( ψ Π( ρ µ µ ψ > ρ, he response of s sronger when he euro area sablzes s exchange rae, snce as menoned above, n hs case Π(ρ>Π(ψ. Ths occurs because when ( ψ > ρ a moneary expanson by he euro area pus pressure on he n currences o apprecae, hence he n auhores need a sronger response n order o defend her exchange rae. Under hs scenaro he welfare effecs are gven by: ( α + α α µ u EST (2 In hs scenaro here are hree effecs on welfare, resulng from an expanson n each of he hree moneary polcy areas. 4.4 Comparng he wo polcy scenaros The polcy opon of exchange rae sablzaon wll be preferred o a polcy of bengn neglec when u u > 0. Analyzng equaon (3 below, s possble o see ha EST BN he second erm s always posve when he degree of nra-regon compeon ( s hgh (so ha α 3 s posve, and he degree of compeon beween euro area and he (ψ s hgher han he degree of compeon beween he and (ρ, such ha Π(ρ>Π(ψ. The reason for hs s ha, when he degree of nra- compeon (ψ s hgher han he degree of compeon beween he and (ρ, s forced o expand by more under he alernave of exchange rae sablzaon. Hence, hs scenaro becomes more aracve for he euro area when he effecs of an n expanson are posve ( > ρ. Π ( α µ α ( ( ρ Π ( ψ u u + EST MST 2 3 Π ( ρ µ (3 2

13 The mpac of he euro area expanson ( α 2, however, can be eher posve or negave. If s negave, hs means ha a moneary expanson by he euro area s beggar-hyself, mplyng, herefore, a rade-off assocaed wh he scenaro of exchange rae sablzaon: on he one hand, under hs scenaro, he n expanson s sronger wh a posve mpac on euro area's welfare bu, on he oher hand, he euro area's own moneary expanson has a negave mpac on welfare. Under hese crcumsances, hs scenaro wll be preferred only f he frs effec s sronger han he second. In order o analyze under wha condons hs may occur, we smulae he welfare resuls for alernave values of he srucural parameers. The resuls are shown n Table. The superscrps are omed because he able only analyses he welfare gans/losses n he euro area. For each alernave, BN and EST, he able shows he conrbuon of he dollar deprecaon o euro area welfare ( ( m moneary polcy ( ( m euro area welfare ( ( m u, he conrbuon of he euro area u o euro area welfare, and he conrbuon of he n peg o u, all mulpled by. I also summarzes he overall welfare gans under each scenaro ( u and he dfference beween he welfare gan under he. polcy alernaves of exchange rae sablzaon and bengn neglec ( ( u EST u BN Table : Comparson beween polcy choces for he euro area, µ ( (2 (3 (4 wes ψ ρ µ BN EST BN EST BN EST BN EST u(m us u(m euro area u(m asa u (u EST -u BN

14 Recall ha he dollar deprecaon (accommodaed by he moneary expanson has bascally he followng effecs n he euro area: expands world demand, mproves he euro area's erms of rade, shfs overall rade away from n goods no ern goods, and whn ern goods shfs rade away from euro area goods no goods. The frs hree effecs are posve. The hrd effec n parcular depends on he sze of he n economy and on he elascy of subsuon beween n and ern goods ( ρ. The las effec s negave and depends on he relave sze of he and on he degree of subsuon beween euro area and goods (ψ. In column ( we smulae a suaon n whch he level of nra-regon compeon ( s lower han he level of exernal compeon (ψ,ρ. 8 In hs case we see ha he subsuon effec of foregn currency deprecaon domnaes. Boh he and n expansons, whch drve up he value of he euro, have a negave mpac on euro area welfare. Under hese parameers, s opmal for he ECB o sablze he euro exchange rae. In column (2 we ncrease he degree of nra-regon compeon (, o where s hgher han he degree of compeon across regon (ψ,ρ. In hs case we see ha he posve effecs of foregn currency deprecaon on world demand and on domesc erms-of-rade domnae. In fac an expanson by he euro area wll be beggar-hyself because reduces welfare relave o he bengn neglec suaon. In he hrd column of he able we can see ha he beggar-hyself effec s reduced when he degree of subsuably beween regons ncreases, and sablzng he exchange rae becomes more aracve. In columns (-(3 we have assumed ha he elascy of subsuon beween and euro area goods s hgher han he elascy of subsuon beween n and ern goods (ern goods beng and euro area goods. Ths s conssen wh a scenaro where he and he euro area produce more smlar goods (less labour-nensve, whle produces goods ha are less smlar o he goods produced by he (more 8 In hs case he nra-regon demand schedules are relavely nelasc; hence an ncrease n demand s assocaed wh a relavely sharp drop n prces. 4

15 labour-nensve. 9 In column (4 we relax hs assumpon by swchng he value of he elascy of subsuon beween he euro area and he (ψ wh he value of he elascy of subsuon beween n and ern goods (ρ. The resuls show ha n hs case n expanson sll has a posve effec on he euro area albe smaller. Ths able shows ha he opmal exchange rae polcy n he euro area crucally depends on he characerscs of rade flows beween he, he euro area, and, and he level of compeon beween and whn hese markes. Furher research amng a quanfyng hese relave degrees of subsuon s essenal for undersandng he consequences of euro apprecaon on he euro area. 5. Conclusons Ths paper apples a hree-counry model o hree regons, he, he euro area, and, o analyze he alernave polcy responses of he moneary auhores n he euro area o a deprecaon of he dollar, assumng ha he n auhores peg her currences o he dollar. The model assumes monopolsc compeon and prce rgdy, whch are sandard assumpons n he NOEM leraure. A deprecaon of he dollar s found o have mulple effecs n he euro area: ( ncreases world demand; ( mproves he euro area's erms of rade; ( shfs overall rade away from n goods no ern goods; and ( shfs rade away from euro area goods no goods, whn he rade n ern goods. The frs hree effecs are posve, whle he fourh s negave. The relave mporance of hese effecs crucally depends on he levels of compeon whn and across regons. We assumed ha n response o he dollar deprecaon, n moneary auhores expand o manan he fxed value of her currences agans he dollar. Ths response 9 We consder he assumpons regardng cross-counry elasces of subsuon plausble, gven he smlares beween he and he euro area economes, whch are maure economes, n conras wh developng n economes, especally Chna. Alhough emprcal evdence s needed o valdae hese assumpons, we do no know of any sudy ha has nvesgaed hs ssue o dae, and we leave o furher research. 5

16 also has mulple effecs on euro area: on he posve sde, expands world demand and mproves euro area erms-of-rade, bu on he negave sde shfs rade away from ern goods no n goods. The posve effecs domnae f he degree of nracounry compeon s hgher han he compeon beween and he. Does he euro area have an ncenve o cural he apprecaon of he euro? I depends. If he degree of nra regon compeon s very low, he sandard Mundel-Flemmng subsuon effecs of foregn currency deprecaon domnae, and euro area has an ncenve o sablze he exchange rae o re-capure world rade and mprove s welfare. On he oher hand, f nra-regon compeon s sronger han compeon beween regons, a moneary expanson by euro area o sablze he value of he euro may be beggar-hyself. Sablzaon n hs case wll only be worhwhle f he degree of compeon beween regons s relavely close o he degree of compeon whn regons. One lmaon of he model s ha he economes are lnearzed around a symmerc seady sae where curren accouns are all balanced. As shown n Lane and Mles- Ferre (200, 2006, when curren accouns are nally mbalanced, valuaon effecs become mporan. Thoenssen (2005 has also shown ha he mpac of he exchange rae on he curren accoun may change dependng on wheher a counry s nally a ne borrower or a ne debor. As menoned earler, however, valuaon effecs are no lkely o be as mporan for he euro area as hey are for (where mos of he counerpar o he large curren accoun defc s, bu hey could affec he ncenves for o abandon he peg. Anoher lmaon of he analyss s ha consders prces o reman consan for one perod. A more realsc assumpon would be o consder Calvo-ype conracs, n whch n every perod a ceran fracon of frms s allowed o change prces. Ths would allow he nroducon of heerogeney n he level of prce rgdy across counres. The model can also be furher exended o allow for alernave polcy nsrumens and shocks, bu a he expense of analycal racably. We leave hese exensons for fuure research. 6

17 REFERENCES Bergn, P. R. (2006. "How well can he New Open Economy Macroeconomcs explan he exchange rae and curren accoun?". Journal of Inernaonal Money and Fnance 25 (5, Clarda, R. (2007. G7 Curren Accoun Imbalances: Susanably and Adjusmen. Chcago, Unversy of Chcago Press for NBER. Corse, G., Pese, P., Roubn, N. and Tlle, C. (2000. "Compeve Devaluaons: Towards a Welfare Based Approach". Jounal of Inernaonal Economcs, 5 (2000, Devereux, M. B., and Genberg, H. (2007. "Currency Apprecaon and Curren Accoun Adjusmen ". Journal of Inernaonal Money and Fnance 26 (4, Fnancal Tmes (2007. Calls grow for ECB nervenon o sem he relenless rse of he euro, Ocober 2. Gournchas, P., and Rey, H. (2005. "Inernaonal Fnancal Adjusmen". NBER Workng Paper No. 55 (Augus. Gournchas, P., and Rey (2007. "From World Banker o World Venure Capals: Exernal Adjusmen and he Exorban Prvlege ". In G7 Curren Accoun Imbalances: Susanably and Adjusmen, eded by Clarda, R. Chcago, Unversy of Chcago Press for NBER. Lane, P. R., and Mles-Ferre, G. M. (2007. "Europe and Global Imbalances". IMF Workng Paper No. 07/44, June. Lane, P. R., and Mles-Ferre, G. M. (2006. The Exernal Wealh of Naons Mark II, IMF Workng Paper No. 06/69, March (forhcomng, Journal of Inernaonal Economcs. Lane, Phlp R., and Mles-Ferre, G. M. (200. The Exernal Wealh of Naons: Measures of Foregn Asses and Lables for Indusral and Developng Counres. Journal of Inernaonal Economcs 55, Mussa, M. (2007. "The dollar and he curren accoun defc: How much should we worry?". Journal of Polcy Modelng 29 (5, Obsfeld, M., and Rogoff, K. (2005. "Global Curren Accoun Imbalances and Exchange Rae Adjusmen". Brookngs Papers on Economc Acvy (, Obsfeld, M., and Rogoff, K. (2000. "New Drecons for Sochasc Open Economy Models", Journal of Inernaonal Economcs 50 (2000, Obsfeld, M., and Rogoff, K. (995. "Exchange Rae Dynamcs Redux ", Journal of 7

18 Polcal Economy 03, Tlle, C. (200. "The Role of Consumpon Subsuably n he Inernaonal Transmsson of Moneary Shocks". Journal of Inernaonal Economcs, 53, Aprl, Thoenssen, C. (2005. "Curren accoun and exchange rae dynamcs and he ne foregn asse poson". In Exchange Raes, Capal Flows and Polcy. eded by Drver, Snclar, and Thoenssen. Rouledge, London. Woodford, M.,and Roemberg, J. (997. "An Opmzaon-Based Economerc Model for he Evaluaon of Moneary Polcy". NBER Macroeconomcs Annual 2:

19 Appendx A. The Model The model s based on Corse e al. (2000's Cenre-Perphery model. The represenave household lvng n regon (,, s assumed o maxmze he followng objecve funcon a me : (A s k 2 M + s U ( + E lnc+ s Y + s χ ln s 0 2 P + s wh all varables as defned n he man ex. s used o denoe euro area varables. The uly maxmzaon s subjec o he sandard budge consran (wh T denong ne axes, and B denong a nomnal bond denomnaed n dollars n zero-ne supply worldwde: E B P Y + M E B M, + + C ( T (A2 P P P P P Gven he defnons n he man ex, he consumpon baskes of he represenave household of counry can be defned as follows: ρ ρ ρ ( C + ( ( C ρ ρ ρ C (A3 C ψ ψ ψ ψ ( C + ( ( C ψ ψ We should also defne he followng consumpon sub-ndexes: C C C ( WEST ( C ( z ( WEST (( C ( z ( ( C ( z 0 WEST WEST Fnally we descrbe he uly-based prce ndexes, defned as he mnmum expendure requred o buy one un of a consumpon baske: P P P ( WEST 0 WEST dz dz ( P ( z WEST ( P ( z WEST ( P ( z dz dz ρ ρ ψ ψ dz dz (A4 (A5 9

20 P P ψ ψ [ ( P + ( ( P ] ρ ( P + ( ( P ψ ρ ρ [ ] Maxmzng (A subjec o (A2 wh respec o holdngs of bonds and money yelds he Euler equaon ( and he money demand equaon (2 n he man ex; whle opmzaon wh respec o oupu yelds he consumpon effor rade-off equaon (3. B. Soluon The soluon sraegy follows Corse e al. (2000. We consder only small shocks and log-lnearze he model around a seady sae n whch B 0. We also follow he sraegy of decomposng he model no dfferences and world averages. B.. Long-run equlbrum Log-lnearzng he prce ndexes around he seady sae equlbrum and usng e e s possble o wre: ( p p p p p p p ( p p + ( ( e ( p p e ( + ( ( p e p ( ( p + ( ( p ( e e ( p + ( e e + ( p p + p (B + Log-lnearzng he Euler equaons, he money marker equlbrum condons, and he long-run consumpon-effor rade-off, yelds respecvely: Aggregang oupu demand: y y y y ψ ψ ρ ρ ( + m p p p c c + y ( p p + y ( p p + y w ( p p + c w ( p p + c Log-lnearzng he long-run curren accoun equaons yelds: e (B2 (B3 (B4 (B5 0 b c + p p + y (B6 20

21 where b db /( C P, for, euro area,, and. In equlbrum: 0 b + b + b b + b Noce n addon ha he long-run money demand equaons and prce ndexes mply : m m m m ( e e ( c c m e ( c c m e ( c c (B7 B... Eas versus From he demand equaons (B5 and he prce ndexes (B s possble o oban: ( p ( P p + e e (B8 y y ρ Usng nsead he consumpon-lesure rade-off (B6 and he demand equaons (B5 also possble o wre: p p + ( e e ( c c (B9 + ρ Subsung hs resul n he dfference beween he and n curren accoun equaons yelds long-run consumpon dfferences n erms f ne foregn asses: + ρ c c b (B0 2ρ Subsung (B0 no resuls (B8 and (B9 gves he long-run dfferences n prces and oupu as a funcon of long-run ne foregn asses: p p ( e e b (B 2ρ y y b (B2 2 To calculae he world aggregaes we ake nsead he averages of he equlbrum w relaons, and we conclude ha y c. I follows ha c y 0. w w w B..2. Inra- The same procedure s followed o oban he nra- long-run soluon, whch are gven by: + ψ c c ( b b 2ψ (B3 p p + e ( b b (B4 2ψ y y 2 ( b b (B5 2

22 B.2. Shor-run Equlbrum To oban he shor-run equlbrum, noce ha prces do no adjus durng he shor-run, ha s p 0. From he Euler equaon c c + ( r s possble o wre: c c c c (B6 c c c c Log-lnearzng he money demand equaons for he shor run, and akng dfferences yelds: m m e ( c c ( e e δ (B7 m m e ( c c ( e e δ where δ. If we assume a permanen moneary expanson: m m, equaons (B7 ogeher wh he long-run money marke equlbrum condons (B7 and he Euler equaons (B6, mply ha he exchange rae jumps mmedaely o s new longrun equlbrum, such ha e e, and c c c c m m e e, and follows ha: m m e e ( e e c c m m Log-lnearzng he curren accoun equlbrum condons yelds: b b b b + c + c + c + c In equlbrum b + b 0. y y y y p p p p (B8 (B9 B.2.. Eas versus Takng he dfference beween he and n long-run curren accoun condons makes possble o oban: b ( ( [ y y ( c c ( e e ] (B20 Takng also he dfferences beween he shor run analog of he goods marke equlbrum condons (B5 yelds: y y ρ e e (B2 ( ( Usng (B20 and (B2, ogeher wh he long-run relaonshp beween ne foregn asses and consumpon (B9 and he second Euler equaon n (B6 s possble o wre: 22

23 2ρ + ρ ( c c ( ρ ( e e ( c c Usng he las equaon n (B8 o subsue for consumpon and rearrangng yelds: ( e e ( e e Π( ( m m (B22 ρ (B23 ( + ρ( + ( + + ρ( where Π( ρ, and s declnng n ρ. Subsung (B23 no (B2 ρ and (B8 makes possble o oban he resuls for relave oupu, relave consumpon:. ( + ρ( + y y m m (B ρ c c c ( ( ( c ( ρ ( ρ + ( ρ ( m m ( + + ρ( Subsung (B23, (B2, and (B9 no he curren accoun equaon (B20 gves he curren accoun balance as a funcon of he moneary shock. 2 ( ρ ( m m ( + + ρ( b (B26 The world aggregaes can be obaned by calculang he weghed sums of he equlbrum equaons: w w w c y. m (B25 B.2.2. Inra- Followng he same sraegy s possble o oban he followng resuls for he nra- varables: ( ( m m e e Π ψ where ( ( + ψ ( + Π ψ, and s declnng n ψ. Usng hs resul n an ψ ( + + ψ ( analogous way as above we can wre: ( ( + ψ + y y m m ( + + ψ ( (B27 ( ψ ( ψ + ( c c c c m m ψ + + ψ (B29 b b ( ( ( 2 ( ψ ( m m ( + + ψ ( (B30 B.3. Overall Effecs The overall effecs are calculaed as he ne presen value of he log-changes of each varable x, such ha x x + x. Usng he resuls above we can wre: 23

24 y y c c y y c c ρ( + ρ ( + ρ( + ψ ( + ψ ( + ψ ( + ρ ρ ψ ψ ( y y ( y y Π Π ( ρ( m m ( ψ ( m m w w (B32 I follows also ha he world aggregaes are gven by: c w y m (B33 B.4. Welfare Effecs The welfare effecs are calculaed usng he log-lnearzed uly funcon excludng uly from lqudy servces, such ha: u c y (B34 Noce ha as for oher varables, each counry/ regon s uly can be decomposed as he sum of world uly and relave ules. I follows from (B32, (B33, and (B34 ha: w w u m ρ ( ( ρ ( + ρ u u y y Π( ρ ( m m ρ + ρ + u u ψ ψ ( ( ( ( ψ ( + ψ y y ( + ψ ( + w Subsung for ( u u no u u + ( ( u u ( ( ( ( ρ + ρ Π ρ ( ρ ( + ρ Π( ρ u ( + m + ( ( Π ( ψ ( m m, allows o wre: [ ( + ρ ( + ( + ρ ( + m ] Ths expresson s equvalen o equaon (7 n he man ex, when we subsue for Π(ρ and defne Λ(ρ as: ( + ρ Λ( ρ ρ + + ρ ( ( Subsung for ( u u no u u ( u u and replacng for u gves equaon (8 n he man ex, when we subsue for Π(ψ and defne Λ(ψ as: ( + ψ Λ( ψ ψ + + ψ ( ( 24

25 B.5. Polcy Responses Recall ha he model soluons for he changes n he dollar exchange raes are gven by: e ( e Π( ( m m ρ (B e Subsung (B2 no (B, gves: e ( ( m m Π ψ (B2 ( Π( ψ ( m m Π( ρ ( m + ( m m I s useful o rearrange he equaon as follows: e ( Π( ρ + ( Π( ψ m ( ( Π( ρ Π( ψ +Π ( ρ m Or e Ω(, ρ, ψ m Γ(, ρ, ψ m + Π( ρ m m where Ω (, ρ, ψ ( Π( ρ + ( Π( ψ Γ(, ρ, ψ ( ( Π( ρ Π( ψ and Π(ρ and Π(ψ are defned as before Ths expresson s equal o zero when: m Π ( ρ + ( Π( ψ Π( ρ m + ( Π ( ρ Π( ψ Π( ρ m 25