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This speech highlights two channels through which globalization poses challenges for monetary policy. The first channel is through the global determination of the average world natural real rate of interest, which implies that saving and investment shifts abroad can influence the domestic interest rate setting consistent with price stability. The second channel is through global digital payments systems, which may compromise domestic policy sovereignty through effects on both monetary and financial stability.

While the globalization of production has been a prominent target of anti-globalization backlash, globalized finance has seemed to be much less in the public bull’s-eye. The blueprint for the post-war international economy agreed at Bretton Woods in 1944 envisioned nothing like today’s extensive and fluid global capital market. The demise of the 1946–73 fixed exchange rate system, however, also brought a progressive dismantling of barriers to international financial flows motivated by special-interest politics, national economic competition, and ideology—alongside the benign desire for a more efficient international allocation of capital. Unfortunately, free cross-border financial capital mobility can compromise governments’ capacities to attain domestic economic and social goals in several ways. This essay links the dynamics of financial liberalization to the Teflon-like resilience of finance to backlash so far, and suggests that stronger backlash could emerge if national governments fail to enhance multilateral cooperation to manage the financial commons.

This paper revisits the debate on ruling out speculative hyperinflations in monetary models. Although apparently a narrow issue, studying these extreme economies turns out to be quite illuminating in understanding the fundamentals of price level determination. It is also relevant in evaluating the broader claims that advocates of the fiscal theory of the price level have made. In Obstfeld and Rogoff ( 1983 , 1986 ) we show that in pure fiat money models with rational expectations, where the government gives no backing whatsoever to currency, there is in fact no reasonable way to rule out speculative hyperinflations where the value of money goes to zero, even if the money supply itself is exogenous and constant. Such perverse equilibria are ruled out, however, if the government provides even a very small real backing to the currency – a fiscal mechanism, but one that comes into play only as a backstop. Indeed that backing does not have to be certain. Cochrane ( 2011 , 2019 ), however, argues that this result is wrong, and that fractional currency backing is a Maginot line that is insufficient to rule out hyperinflation. We show here why, in fact, his analysis involves a subtle change in model specification that adds a distinct monetary fragility to our model. Our baseline analysis uses a canonical money-in-the-utility-function setup due to Brock ( 1974 , 1975 ), but following Wallace (1981) , we show the same results go through in an overlapping-generations model of money.

Fifty years ago, Harry G. Johnson published “The Case for Flexible Exchange Rates, 1969,” its title echoing Milton Friedman’s classic essay of the early 1950s. Though somewhat forgotten today, Johnson’s reprise was an important element in the late 1960s debate over the future of the international monetary system. The present paper has three objectives. The first is to lay out the historical context in which Johnson’s “Case” was written and read. The second is to examine Johnson’s main points and see how they stand up to nearly five decades of experience with floating exchange rates since the end of the Bretton Woods system. The third is to review the most recent academic critiques of exchange-rate flexibility and ask how fatal they are to Johnson’s basic argument. I conclude that the essential case for exchange rate flexibility still stands strong.

This paper examines the claim that exchange rate regimes are of little relevance in the transmission of global financial conditions to domestic financial and macroeconomic conditions. Our findings suggest that exchange rate regimes do matter, at least for emerging market economies. The transmission of global financial shocks to domestic variables is magnified under fixed exchange rate regimes relative to more flexible regimes. For advanced economies, however, the jury is still out, as the recent paucity of truly fixed regimes among these economies poses a challenge for estimating the effect of exchange rate flexibility.

In our book, Global Capital Markets: Integration, Crisis, and Growth, we traced out the evolution of the international monetary system using the framework of the “international monetary trilemma”: countries can enjoy at most two from the set {exchange-rate stability, open capital markets, and domestic monetary autonomy}. The events of the past decade or more highlight the further complications for this framework posed by financial stability issues. Here we update and qualify our prior analysis, drawing on recent experience and research. Under the classical gold standard, scant attention was paid to macro management, either to stabilize output and employment or to ensure financial stability. The interwar years highlighted the changing demands for modern central bank interventions in the economy. Financial instability, followed by WWII, left a world with sharply constricted financial markets and little private cross-border capital mobility. Due to this historical accident, the Bretton Woods system agreed in 1944 focused not at all on financial stability, and focused on issues like adjustment, exchange rate misalignment, and international liquidity (defined in terms of official, not private, capital-account transactions). Post 1970s floating rates permitted, but did not require, liberalization of the capital account. But the political equilibrium had shifted in favor of financial interests, signaled by the push toward European integration and the later reform process in emerging markets starting in the 1990s. This development, however, opened the door once again to domestic financial crises and their international transmission. Countries now become more susceptible to a new species of “capital account crises,” fueled by bank and bond lending, and its sudden withdrawal. These developments, in fact, made evident a different, “financial trilemma”: countries can pick at most two from {financial stability, open capital markets, and autonomy over domestic financial policy}. We distill the main lessons as to the interactions between the monetary and financial trilemmas, and policies that could best address the resulting weaknesses.

Fifty years ago, Harry G. Johnson published “The Case for Flexible Exchange Rates, 1969,” its title echoing Milton Friedman’s classic essay of 1953. Though somewhat overlooked today, Johnson’s reprise was an important element in the late 1960s debate over the future of the international monetary system. The present paper has three objectives. The first is to lay out the historical context in which Johnson’s “Case” was written and read. The second is to examine Johnson’s main points and see how they stand up to nearly five decades of experience with floating exchange rates since the end of the Bretton Woods system. The third is to review the most recent academic critiques of exchange rate flexibility and ask how fatal they are to Johnson’s basic argument. I conclude that the essential case for exchange rate flexibility still stands strong.

This paper is a partial exploration of mechanisms through which global factors influence the tradeoffs that U.S. monetary policy faces. It considers three main channels. The first is the determination of domestic inflation in a context where international prices and global competition play a role, alongside domestic slack and inflation expectations. The second channel is the determination of asset returns (including the natural real safe rate of interest, r*) and financial conditions, given integration with global financial markets. The third channel, which is particular to the United States, is the potential spillback onto the U.S. economy from the disproportionate impact of U.S. monetary policy on the outside world. In themselves, global factors need not undermine a central bank's ability to control the price level over the long term -- after all, it is the monopoly issuer of the numeraire in which domestic prices are measured. Over shorter horizons, however, global factors do change the tradeoff between price-level control and other goals such as low unemployment and financial stability, thereby affecting the policy cost of attaining a given price path.

This paper studies how several macrofinancial factors are associated over time with the evolution of covered interest parity (CIP) deviations in the decade after the Global Financial Crisis. Changes in a number of risk- and policy-related factors have a significant association with the evolution of CIP deviations. Key measures of FX market liquidity and intermediaries' risk-taking capacity are strongly correlated with the cross-currency basis (the deviation from CIP), and the close relationship between broad U.S. dollar strength and the basis is driven mainly by a common factor depending on other safe-haven currencies' comovements. Post-crisis monetary policies also play a role, as demonstrated by the relationship between CIP deviations, central bank balance sheets, and term premia. Risk-related factors have more explanatory power than monetary policy-related factors over the entire 2010–2018 period, but they are approximately equally influential over the period's second half. Further highlighting the role of bank regulation, we offer evidence that the year-end dynamics of the three-month dollar basis depend on financial regulations targeting global systemically important financial institutions.

This speech highlights two channels through which globalization poses challenges for monetary policy. The first channel is through the global determination of the average world natural real rate of interest, which implies that saving and investment shifts abroad can influence the domestic interest rate setting consistent with price stability. The second channel is through global digital payments systems, which may compromise domestic policy sovereignty through effects on both monetary and financial stability.

This paper is a partial exploration of mechanisms through which global factors influence the tradeoffs that US monetary policy faces. It considers three main channels. The first is the determination of domestic inflation in a context where international prices and global competition play a role, alongside domestic slack and inflation expectations. The second channel is the determination of asset returns (including the natural real safe rate of interest, r*) and financial conditions, given integration with global financial markets. The third channel, which is particular to the United States, is the potential spillback onto the US economy from the disproportionate impact of US monetary policy on the outside world. In themselves, global factors need not undermine a central bank's ability to control the price level over the long term--after all, it is the monopoly issuer of the numeraire in which domestic prices are measured. Over shorter horizons, however, global factors do change the tradeoff between price-level control and other goals such as low unemployment and financial stability, thereby affecting the policy cost of attaining a given price path.

Greater financial integration between core and peripheral European Monetary Union (EMU) members not only had an effect on both sets of countries but also spilled over beyond the euro area. Lower interest rates allowed peripheral countries to run bigger deficits, which inflated their economies by allowing credit booms. Core EMU countries took on extra foreign leverage to expose themselves to the peripherals. We present a stylized model that illustrates possible mechanisms for these developments. We then analyze the geography of international debt flows using multiple data sources and provide evidence that after the euro's introduction, core EMU countries increased their borrowing from outside of the EMU and their lending to the EMU periphery. Moreover, we present evidence that large core EMU banks' lending to periphery borrowers was linked to their borrowing from outside of the euro area.

On June 23, 2016, the United Kingdom’s vote to leave the European Union came amid widespread professional forecasts of financial volatility, a likely growth slowdown for the United Kingdom, and potential spillovers to the rest of the EU and even to countries outside the EU’s Single Market. After a relatively brief interlude of jitters, however, equity markets recovered and interbank stains were avoided (albeit with central bank support). The main durable financial market effect has been a substantial depreciation of the pound sterling. At the same time, economic signals from the U.K. economy have been mixed, with fairly robust consumer spending and exports sustaining the economy so far. The shape of the ultimate terms of trade between Britain and its former EU partners remains unclear, however, and the uncertainty seems likely to weigh on future investment and hiring. It is unlikely that substantial U.K. control over the free movement of EU persons across its borders—a main objective of the pro-Brexit campaign—will prove compatible with anything near full access to the Single Market. Moreover, any eventual loss of access to the Single Market, including for financial services, will very likely reduce the United Kingdom’s steady-state income.

A cross-country comparative analysis shows that there is substantial room for further integration of China into global financial markets, especially in the case of the international bond market. A further successful liberalization of the Chinese bond market would encompass not only loosening bond market regulations, but also further developing of other markets, notably the foreign exchange market. Even though the increased integration of China into international capital markets would increase its exposure to the global financial cycle, the costs in terms of monetary autonomy would not be large given China’s size and especially under a well-articulated macroeconomic framework.

Stanley Fischer is a rarity among economic policymakers. He came to the policy world as an internationally recognized intellectual leader on macroeconomic theory and policy. He confronted numerous emerging market crises, including the globally systemic Asian crisis, as the IMF’s First Deputy Managing Director from September 1994 to August 2001. And then, as governor of an emerging economy’s central bank starting in May 2005, he decided the monetary responses to the worldwide crisis of 2008–09 and its aftershocks. Fischer’s unpublished Robbins Lectures, delivered at the London School of Economics late in 2001, drew lessons from his service at the IMF. Did emerging markets follow up on those lessons, and did their preparations help them weather the storm of 2008–09? How have economists’ views, and Fischer’s, changed as a result of the global financial crisis? This paper proposes answers to these questions, focusing on the experiences of three Asian crisis countries, Indonesia, Korea, and Thailand.

Do global current account imbalances still matter in a world of deep international financial markets where gross two-way financial flows often dwarf the net flows measured in the current account? Contrary to a complete markets or 'consenting adults' view of the world, large current account imbalances, while very possibly warranted by fundamentals and welcome, can also signal elevated macroeconomic and financial stresses, as was arguably the case in the mid-2000s. Furthermore, the increasingly big valuation changes in countries’ net international investment positions, while potentially important in risk allocation, cannot be relied upon systematically to offset the changes in national wealth implied by the current account. The same factors that dictate careful attention to global imbalances also imply, however, that data on gross international financial flows and positions are central to any assessment of financial stability risks. The balance sheet mismatches of leveraged entities provide the most direct indicators of potential instability, much more so than do global imbalances, though the imbalances may well be a symptom that deeper financial threats are gathering.

A key precursor of twentieth-century financial crises in emerging and advanced economies alike was the rapid buildup of leverage. Those emerging economies that avoided leverage booms during the 2000s also were most likely to avoid the worst effects of the twenty-first century's first global crisis. A discrete-choice panel analysis using 1973–2010 data suggests that domestic credit expansion and real currency appreciation have been the most robust and significant predictors of financial crises, regardless of whether a country is emerging or advanced. For emerging economies, however, higher foreign exchange reserves predict a sharply reduced probability of a subsequent crisis. (JEL E44, F34, F44, G01, G21, O19)

All schemes to enhance global liquidity require a higher level of fiscal support and coordination from the international community. Loans to troubled sovereigns or financial institutions imply a credit risk that ultimately must be lodged somewhere. Expanded international lending facilities, including an expanded International Monetary Fund, require an expanded level of fiscal backup. The same point obviously applies to the European framework for managing internal sovereign debt problems, including proposals for a jointly guaranteed euro zone sovereign bond. Even attainment of a significant role for the Special Drawing Right depends upon enhanced fiscal resources and burden sharing at the international level.

In this paper we connect the events of the last twelve months, "The Panic of 2008" as it has been called, to the demand for international reserves. In previous work, we have shown that international reserve demand can be rationalized by a central bank's desire to backstop the broad money supply to avert the possibility of an internal/external double drain (a bank run combined with capital flight). Thus, simply looking at trade or short-term debt as motivations for reserve holdings is insufficient; one must also consider the size of the banking system (M2). Here, we show that a country's reserve holdings just before the current crisis, relative to their predicted holdings based on these financial motives, can significantly predict exchange rate movements of both emerging and advanced countries in 2008. Countries with large war chests did not depreciate -- and some appreciated. Meanwhile, those who held insufficient reserves based on our metric were likely to depreciate. Current account balances and short-term debt levels are not statistically significant predictors of depreciation once reserve levels are taken into account. Our model's typically high predicted reserve levels provide important context for the unprecedented U.S. dollar swap lines recently provided to many countries by the Federal Reserve.(This abstract was borrowed from another version of this item.)

Despite an abundance of cross-sectional, panel, and event studies, there is strikingly little convincing documentation of direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries. The econometric difficulties are similar to those that bedevil the literature on trade openness and growth though, if anything, they are more severe in the context of international finance. There is also little systematic evidence that financial opening raises welfare indirectly by promoting collateral reforms of economic institutions or policies. At the same time, opening the financial account does appear to raise the frequency and severity of economic crises. Nonetheless, developing countries continue to move in the direction of further financial openness. A plausible explanation is that financial development is a concomitant of successful economic growth, and a growing financial sector in an economy open to trade cannot long be insulated from cross-border financial flows. This survey discusses the policy framework in which financial globalization is most likely to prove beneficial for developing countries. The reforms developing countries need to carry out to make their economies safe for international asset trade are the same reforms they need to carry out to curtail the power of entrenched economic interests and liberate the economy's productive potential. IMF Staff Papers (2009) 56, 63–111. doi:10.1057/imfsp.2008.32

This paper revisits the sticky-price pricing-to-market model of Devereux and Engel [Devereux, M.B., Engel, C., 2003. Monetary policy in the open economy revisited: price setting and exchange-rate flexibility. Review of Economic Studies 70(4), 765–783], in which fixed exchange rates are optimal even in the face of country-specific nonmonetary shocks. We show that this result hinges critically on the Devereux–Engel model's prediction that international consumption levels are perfectly synchronized under flexible prices. Realistic modifications of the model that produce nonsynchronous consumption movements – such as, the presence of nontraded goods – upset the fixed exchange rate prescription even in the absence of an expenditure-switching role of exchange rate changes.

These remarks were presented at the 2008 International Conference, gFrontiers in Monetary Theory and Policy, h held by the Institute for Monetary and Economic Studies, Bank of Japan, in Tokyo on May 28-29, 2008.

Greater financial integration between core and peripheral European Monetary Union (EMU) members not only had an effect on both sets of countries but also spilled over beyond the euro area. Lower interest rates allowed peripheral countries to run bigger deficits, which inflated their economies by allowing credit booms. Core EMU countries took on extra foreign leverage to expose themselves to the peripherals. We present a stylized model that illustrates possible mechanisms for these developments. We then analyze the geography of international debt flows using multiple data sources and provide evidence that after the euro’s introduction, core EMU countries increased their borrowing from outside of the EMU and their lending to the EMU periphery. Moreover, we present evidence that large core EMU banks’ lending to periphery borrowers was linked to their borrowing from outside of the euro area.

Routine publication of the forecast path for the policy interest rate (i.e. “conventional forward guidance”) would improve the transparency of monetary policy. It would also improve policy effectiveness through its influence on expectations, particularly when there is a risk of low inflation, and the policy rate is constrained by the effective lower bound. Model simulations indicate that a potent macroeconomic strategy, for returning the Canadian economy to potential, combines conventional forward guidance with a fiscal stimulus. As a response to the effective lower bound constraint, and the decline in the world equilibrium real interest rate, this strategy is preferable to raising the inflation target.

The exchange-rate regime is often seen as constrained by the monetary policy trilemma, which imposes a stark tradeoff among exchange stability, monetary independence, and capital market openness. Yet the trilemma has not gone without challenge. Some argue that under the modern float there could be limited monetary autonomy; others, that even under the classical gold standard domestic monetary autonomy was considerable. This paper studies the coherence of international interest rates over more than 130 years. The constraints implied by the trilemma are largely borne out by history. © 2005 President and Fellows of Harvard College and the Massachusetts Institute of Technology.

THIS IS THE third in a series of papers we have written over the past five years about the growing U.S. current account deficit and the potentially sharp exchange rate movements any future adjustment toward current account balance might imply. (1) The problem has hardly gone away in those five years. Indeed, the U.S. current account deficit today is running at around 6 percent of GDP, an all-time record. Incredibly, the U.S. deficit now soaks up about 75 percent of the combined current account surpluses of Germany, Japan, China, and all the world's other surplus countries. (2) To balance its current account simply through higher exports, the United States would have to increase export revenue by a staggering 58 percent over 2004 levels. And, as we argue in this paper, the speed at which the U.S. current account ultimately returns toward balance, the triggers that drive that adjustment, and the way in which the burden of adjustment is allocated across Europe and Asia all have enormous implications for global exchange rates. Each scenario for returning to balance poses, in turn, its own risks to financial markets and to general economic stability. Our assessment is that the risks of collateral damage--beyond the risks to exchange rate stability--have grown substantially over the five years since our first research paper on the topic, partly because the U.S. current account deficit itself has grown, but mainly because of a mix of other factors. These include, not least, the stunningly low U.S. personal saving rate (which, driven by unsustainable rates of housing appreciation and record low interest rates, fell to 1 percent of disposable personal income in 2004). But additional major risks are posed by the sharp deterioration in the U.S. federal government's fiscal trajectory since 2000, rising energy prices, and the fact that the United States has become increasingly dependent on Asian central banks and politically unstable oil producers to finance its deficits. To these vulnerabilities must be added Europe's conspicuously inflexible economy, Japan's continuing dependence on export-driven growth, the susceptibility of emerging markets to any kind of global financial volatility, and the fact that, increasingly, the counterparties in international asset transactions are insurance companies, hedge funds, and other relatively unregulated nonbank financial entities. Perhaps above all, geopolitical risks and the threat of international terror have risen markedly since September 2001, confronting the United States with open-ended long-term costs for financing wars and homeland security. True, if some shock (such as a rise in foreign demand for U.S. exports) were to close up these global imbalances quickly without exposing any concomitant weaknesses, the damage might well be contained to exchange rates and to the collapse of a few large banks and financial firms--along with, perhaps, mild recession in Europe and Japan. But, given the broader risks, it seems prudent to try to find policies that will gradually reduce global imbalances now rather than later. Such policies would include finding ways to reverse the decline in U.S. saving, particularly by developing a more credible strategy to eliminate the structural federal budget deficit and to tackle the country's actuarially insolvent old-age pension and medical benefit programs. More rapid productivity growth in the rest of the world would be particularly helpful in achieving a benign adjustment, but only, as the model we develop in this paper illustrates, if that growth is concentrated in nontraded (domestically produced and consumed) goods rather than the export sector, where such productivity growth could actually widen the U.S. trade deficit. It is also essential that Asia, which now accounts for more than one-third of global output on a purchasing power parity basis, take responsibility for bearing its share of the burden of adjustment. Otherwise, if demand shifts caused the U. …

We develop a three-region economic model to assess how a significant reduction in global current account imbalances might impact dollar, euro, and Asian real exchange rates under alternative scenarios. Sizable exchange rate shifts appear to be a necessary corollary of adjustment even under otherwise relatively benign scenarios where appropriate policy actions are taken (for example, to raise U.S. national saving or to make Asian exchange rates more flexible). Our baseline estimate suggests that a halving of the U.S. current account deficit would entail nearly a 20 percent appreciation of Asian real exchange rates versus the dollar and a slightly smaller rise in European currencies. Although an adverse scenario is not the most likely outcome, the risks appear to be significantly higher than they were five years ago.

The interwar period was marked by the end of the classical gold standard regime and new levels of macroeconomic disorder in the world economy. The interwar disorder often is linked to policies inconsistent with the constraint of the open-economy trilemma—the inability of policymakers simultaneously to pursue a fixed exchange rate, open capital markets, and autonomous monetary policy. The first two objectives were linchpins of the pre-1914 order. As increasingly democratic polities faced pressures to engage in domestic macroeconomic management, however, either currency pegs or freedom of capital movements had to yield. This historical analytic narrative is compelling—with significant ramifications for today’s world, if true—but empirically controversial. We apply theory and empirics to the interwar data and find strong support for the logic of the trilemma. Thus, an inability to pursue consistent policies in a rapidly changing political and economic environment appears central to an understanding of the interwar crises, and the same constraints still apply today.

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. In an earlier paper, we showed that this reasoning does not hold, that open-market operations can provide substantial macroeconomic benefits and facilitate the use of powerful fiscal policy tools even in a liquidity trap. In this paper, we consider an alternative approach that has been suggested for use in a liquidity trap, a scheduled increase in consumption tax rates. We find that such a policy could, indeed, increase short-run consumption, but would be less effective at increasing welfare or accelerating a country's exit from a liquidity trap. Though a variant of this tax policy might induce exit from a liquidity trap, the impact of welfare is negative in this case as well. We also argue that this alternative tax-rate-based approach is subject to more severe credibility problems than the monetary policy approach explored in our original paper.

This paper evaluates the capacity of emerging market economies (EMEs) to moderate the domestic impact of global financial and monetary forces through their own monetary policies. Those EMEs that are able to exploit a flexible exchange rate are far better positioned than those that devote monetary policy to fixing the rate - a reflection of the classical monetary policy trilemma. However, exchange rate changes alone do not insulate economies from foreign financial and monetary shocks. While potentially a potent source of economic benefits, financial globalisation does have a downside for economic management. It worsens the trade-offs monetary policy faces in navigating among multiple domestic objectives. This drawback of globalisation raises the marginal value of additional tools of macroeconomic and financial policy. Unfortunately, the availability of such tools is constrained by a financial policy trilemma that is distinct from the monetary trilemma. This second trilemma posits the incompatibility of national responsibility for financial policy, international financial integration and financial stability.

The elasticity of substitution between goods from different countries---the Armington elasticity---is important for many questions in international economics, but its magnitude is subject to debate: the "macro" elasticity between home and import goods is often found to be smaller than the "micro" elasticity between foreign sources of imports. We investigate these two elasticities in a model using a nested CES preference structure. We explore estimation techniques for the macro and micro elasticities using both simulated data from a Melitz-style model, and highly disaggregate U.S. production data matched to Harmonized System trade data. We find that in up to one-half of goods there is no significant difference between the macro and micro elasticities, but in the other half of goods the macro elasticity is significantly lower than the micro elasticity, even when they are estimated at the same level of disaggregation.

This paper analyzes the constraints European Union law places on the 1 January 1999 choices of irrevocably fixed conversion rates between the Euro and the currencies of EMU members states. Current EU legislation, notably the Maastricht treaty, requires that the bilateral currency conversion factors implied by the 1 January 1999 choices equal closing market exchange rates on 31 December 1998. Given that legal constraint, there still exist several strategies for choosing the relative prices of EMU member currencies against the Euro. Unfortunately, most of these have potentially damaging side effects. One approach, based on official Stage 2 offers of contingent Euro forward contracts with value dates at the start of Stage 3, allows a highly credible preannouncement of the bilateral currency conversion factors to be set at the start of EMU. That approach assumes, however, that no prospective EMU members can withdraw between their selection in May 1998 and the start of Stage 3.

Asymmetric shocks Regional non-adjustment and fiscal policy How will countries handle idiosyncratic macroeconomic shocks under the single currency? Since the regional adjustment patterns currently prevailing within European currency unions are likely to prevail at the national level under the single currency, looking at the ways in which European countries react to internally asymmetric shocks today provides a good preview for the answer to that question. In this paper, we compare the USA with Germany, Italy and the UK, and with Canada, which is closer to Europe than the USA in its labour market and fiscal institutions. Europe's (and to some extent Canada's) model of regional response differs from that of the USA. Changes in regional real exchange rates are small in all countries. Outside of the USA, however, there is more reliance on interregional transfer payments, less on labour migration, and the pace of regional adjustment appears to be slower. If EMU aims at the same degree of economic and social cohesion that its constituent nations enjoy today, this suggests that its members may find it hard to resist the eventual extension of existing EU mechanisms of income redistribution - a transfer union. We propose an alternative strategy based on a relaxed Stability Pact, further strictures against central EU borrowing, labour market and fiscal reform, and the issuance by individual member states of debt indexed to nominal GDP. — Maurice Obstfeld and Giovanni Peri

This paper surveys recent research in open-economy macroeconomics, using questions raised by European economic and monetary unification to guide the topics discussed. A striking empirical regularity is the tendency for changes in the nominal exchange rate regime systematically to affect the variability of nominal and real exchange rates alike. This regularity (which disappears in high-inflation conditions) can be explained by sticky-price theories or by models of asset-market liquidity effects. But plausible liquidity models have difficulty generating enough persistence (in output and real exchange rates, in particular) to match the data. Thus the macroeconomic costs of giving up the exchange-rate realignment option, emphasized in Mundell's optimum currency area concept, seem empirically relevant. The paper discusses other possible costs of currency unification associated with a reduced number of asset markets. On the benefit side, our theories of the efficiences due to a common currency remain unsatisfactory, despite recent advances. A key motivation for the choice of a common currency over a fixed exchange rate between national currencies is the fear of speculative attack. The paper concludes by showing how self-fulfilling currency crises can occur, and describes recent progress in narrowing the range of multiple equilibria in adjustable-peg regimes.