The Optimal Currency Area in a Liquidity Trap

49 Pages Posted: 1 Nov 2013 Last revised: 7 Nov 2013

See all articles by David E. Cook

David E. Cook

Hong Kong University of Science & Technology (HKUST) - Department of Economics; Hong Kong University of Science & Technology (HKUST) - Department of Economics

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: October 2013

Abstract

Open economy macro theory says that when a country is subject to idiosyncratic macro shocks, it should have its own currency and a flexible exchange rate. But recently in many countries policy rates have been pushed down close to the lower bound, limiting the ability of policy-makers to accommodate shocks, even in open economies with flexible exchange rates. In this paper, we show that if the zero bound constraint is binding and policy lacks an effective `forward guidance' mechanism, a flexible exchange rate system may be inferior to a single currency area, even when there are country-specific macro shocks. When monetary policy is constrained by the zero bound, under independent currencies with flexible exchange rates, the exchange rate exacerbates the impact of shocks. Remarkably, this may hold true even if only a subset of countries are constrained by the zero bound, and other countries freely adjust their interest rates. In order for a regime of multiple currencies to dominate a single currency area in a liquidity trap environment, it is necessary to have effective forward guidance in monetary policy.

Suggested Citation

Cook, David E. and Devereux, Michael B., The Optimal Currency Area in a Liquidity Trap (October 2013). NBER Working Paper No. w19588, Available at SSRN: https://ssrn.com/abstract=2348459

David E. Cook (Contact Author)

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
2538 7614 (Phone)

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
2538 7614 (Phone)

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada
604-822-2542 (Phone)
604-946-6271 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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