The Economics Book

252

B

y the early 1960s the

institutions of the post-war

economies were well

established. Toward the end of

World War II the Bretton Woods

system (pp.186–87) was set up to

regulate the financial relations

between the big industrial states,

basing Western capitalism on a

system of fixed exchange rates that

controlled the flows of capital and

money worldwide. International

trade had recovered after the slump

of the interwar years, and economic

growth was rapid.

However, there were glitches in

this system. First there were

problems with balance of payments

—the difference between what a

country pays for imports and what

it earns from exports. Balance of

payments crises occurred because

countries could not easily adjust

their exchange rates within the

international system. Coupled with

tight labor markets and inflexible

domestic prices, the previously

automatic, market-led mechanisms

that allowed countries to adjust to

external economic shocks did not

function very well. The result was

a series of crises that arose when

countries were unable to pay for

imports by using the proceeds

of their exports. Alongside this,

a series of moves toward the

integration of European economies

began to float the possibility of a

currency union between European

countries. This started with the

Treaty of Paris in 1951, which

established common trading

areas for coal and steel. In 1961,

Canadian economist Robert

Mundell was the first to attempt

an analysis of what he called an

“optimal currency area.”

Currency areas

Mundell sought to answer what

might at first seem an odd

question: over what geographical

area should one type of currency be

used? At the time this issue had

barely been posed. It had simply

been taken for granted that national

economies used their own national

currencies. The idea that this might

not be the best arrangement had

not really occurred to anyone.

Mundell realized that while history

had provided nations with their

own currencies, this did not mean

it had provided them with the best

possible currency arrangements.

There were clearly costs involved in

EXCHANGE RATES AND CURRENCIES

IN CONTEXT

FOCUS

Global economy

KEY THINKER

Robert Mundell (1932– )

BEFORE

1953 Milton Friedman argues

that freely floating exchange

rates would enable market

forces to resolve problems

with balance of payments (the

difference between the value

of exports and imports).

AFTER

1963 US economist Ronald

McKinnon shows that small

economies would benefit from

a currency union since they

can mitigate shocks better

than large economies.

1996 US economists Jeffrey

Frankel and Andrew Rose

argue that the criteria for

a currency area are

themselves affected by prior

economic development.

Different regions

specialize in producing

different goods.

Specialization leads to

trade between regions.

Similar economies

can benefit from a

single currency.

But trading in multiple

currencies creates

additional costs.

... there is no need for

exchange rates tailored

to local conditions.

These costs can be

eliminated if the regions are

in similar phases of growth

and slump because...