Exchange Rate Economics: Theories and Evidence

Introduction 35
internal–external balance (see Chapter 9 for a discussion of this concept) is easier
to attain.
Third,Kenen (1963) focused on the degree to which an economy’s industrial
structure is diversified as the key OCA criterion. For example,if a country,or
region,exports a wide variety of goods then in the presence of relative demand
shocks and technology shocks,the effect of a shock on output will be less than
the effect on individual industries. So a diversified economy will have less need
for exchange rate flexibility in order to mitigate against the effects of shocks; conversely,an
economy that is little diversified would gain from having a flexible
exchange rate.
Taken together these criteria could give conflicting indications of the appropriate
exchange rate regime. For example,a country with low labour and capital mobility
should have a flexible rate under that criterion,but if it also has a high degree
of trade openness it should have a fixed rate regime. Such potential ambiguity
of the single criterion approach has been criticised by,for example,Argy and
de Grauwe (1990),and although attempts have been made to provide a more
general theoretical OCA framework these have not proved to be very satisfactory.
Recently,therefore,attention has turned from the single criterion approach to an
analysis of the shocks affecting economies or regions,since ‘shock absorption’ is
seen to combine the net influence of several of the traditional criteria (Masson and
Taylor 1993). There are a number of different aspects to this approach: are shocks
symmetric or asymmetric?; are the shocks temporary or permanent?; what are the
origins of the shocks – are they real nominal/domestic foreign?
Consider first the evidence on whether shocks are symmetrical or not. The evidence
on this issue has focussed on the extent to which business cycles are correlated
across regions and countries. A high correlation is taken to be prima facie evidence
that shocks are symmetrical,whereas a low correlation is thought to be more
indicative of asymmetric shocks. A large number of studies have demonstrated
that business cycles correlations of European economies in the 1980s became more
associated with the German business cycle than the US cycle.
De Grauwe and Vanhaverbeke (1993) are a first cut at regional cycles and they
showed that in the 1980s output and employment variability in Europe had been
higher at the regional than at the national level (the UK regions were not included in
this study). Forni and Reichlin (2001) confirmed this,although they demonstrated
that in both the UK and Greece there are strong country-specific cycles. This latter
finding was confirmed by Barrios et al. (2001) for the UK. They demonstrate that
there is only minor cyclical heterogeneity amongst the UK regions,the average
correlation coefficient being approximately 0.7. Clark and van Wincoop (2000)
confirm that inter-regional business cycle correlation is high – at about 0.7 – for
regions within countries,but only in the range of 0.2 to 0.4 for regions at similar
levels of economic development across countries.
Usefully,Rose and Engel (2000) present evidence that membership of a monetary
union tends to increase the business cycle correlation by about 0.1,and
conclude that ‘while economically and statistically significant,the size of this effect
is small in an absolute sense’ (page 19).