Should the United States and Europe's Economic and Monetary Union Stabilize the Exchange Rate?

Abstract

This paper examines the likelihood that the United States would engage in a policy of exchange rate stabilization with the EMU. First, it examines the history of the exchange rate regimes in the United States and a review of literature on exchange rate theories. From a historical perspective, most literature and prominent economic theories focus on the Milton Friedman proposal of floating exchange rate regimes. Just as floating exchange rates were gaining prominence in the United States during the 1970s, European countries were attempting to compose a currency union which took the form of the European Monetary System in the late 1970s and eventually evolved into Europe’s Economic and Monetary Union which completed its last stage of development January 1, 1999. The importance of fixed exchange rate regimes and theories, most notably, Robert Mundell’s Theory of Optimal Currency Area is highlighted. In addition, the paradigm arguments on the relation between trade integration and synchronization of business cycles are discussed utilizing Paul Krugman and Tony Venables’ specialization hypothesis (1996) and comparing it to Jeffrey Frankel and Andrew Rose’ endogeneity hypothesis (1998). Second, this analysis shows that the United States’ economy is at a critical point in time in which it must reevaluate its stance on floating exchange rates. Particular attention is paid to current economic conditions in the United States and the EMU such as: the purchasing power of the euro with respect to the U.S. dollar, the recent decline of the dollar, the lackluster performance of the EMU with regard to some macroeconomic variables, and the profligate spending by the U.S. government which has contributed to the tremendous budget deficit. Third, this paper analyzes six properties of optimal currency area criteria: degree of economic openness, trade integration and similarity of economic structure, financial market integration, synchronization of business cycles, price flexibility, and mobility of labor as a factor of production. The countries of France and Germany are utilized as benchmarks (if they satisfy the criterion) against which the United States and EMU are compared. The time periods of (1946-1972) and (1973-2003) are utilized to highlight the advantages and disadvantages of various exchange rate regimes and to try and shed light on the endogeneity hypothesis and specialization hypothesis. This thesis concludes that France and Germany failed to satisfy certain OCA criteria such as business cycle synchronization, price flexibility, and mobility of labor as a factor of production. Although France and Germany did not fulfill all of the OCA properties, the United States and the EMU appear to be farther from optimality, only satisfying mobility of labor as a factor of production. Finally, according to this paper neither the endogeneity hypothesis nor the specialization hypothesis dominates. Therefore, the United States should not stabilize rates with the EMU because it will most likely incur greater costs than benefits since it does not form an optimal currency area with the EMU. Intermediate exchange rate policies should be evaluated and further research conducted to enhance OCA criteria and make it a more scientific and effective tool for policymakers. The findings of this paper shed light on the history of exchange rate regimes, exchange rate theories, and current economic conditions that warrant a reevaluation of the United States’ foreign exchange rate position while at the same time indicating which characteristics of the U.S. economy satisfy optimality and emphasizing the importance of further research in this field.