Is the exchange rate an adjustment mechanism?

The Optimal Currency Areas theory arose in the early sixties of the last Century as an extension of the literature on the choice between fixed or flexible exchange. According to that, the main cost of joining a monetary union would be the loss of flexibility for macroeconomic stabilization policy when giving up the exchange rate policy. But in a world of free capital mobility and growing capital markets, followed by continuous liberalization and deregulation of capital movements, as have taken place in recent years, exchange rates become a source of destabilization. Moreover, recent experiences (such as the crisis of Argentina in 1975, the European Monetary System in 1992, Mexico in 1994, Southeast Asia in 1997, Russia in 1998 and Argentina in 2002) have shown the increasing difficulty for a country to build the reputation needed to sustain a fixed exchange rate system.

In this environment, the adoption of a common currency, rather than a fixed exchange rate, with other related countries constitutes an alternative to avoid asymmetric disturbances coming from currency crisis. And as was the case for the credibility of anti-inflationary policy, the elimination of transaction costs and exchange rate uncertainty would be achieved much more clearly in a monetary union that in a system of fixed exchange rates, since there will not be necessary policy interventions to sustain central parity. This, in turn, should help to increase the flow of international trade and investment and, through a more efficient use of resources, a favourable result in the evolution of productivity and economic growth.

This paper is devoted to analyse the role played by the exchange rate as a stabilization tool in open economies. The results will show how its effectiveness would depend on the degree of capital mobility and the efficiency of foreign exchange markets.