ABSTRACT
The question of whether to maintain a floating exchange rate, adopt some form of fixity or even some other state’s currency is complex and, arguably, is not one on which we have any clear prescription. Even the eleven founder members of the European Monetary Union were generally regarded as embarking on a great adventure rather than any necessary economic policy. The theory of optimal currency areas, developed by Mundell (1961), has provided the starting point for much of the economic debate. We can sum up the resulting macroeconomic prescription as follows. Given sticky prices and imperfect factor mobility, the presence of significant real asymmetric shocks will lead to welfare gains when a floating exchange rate is maintained, against the alternative of a fixed exchange rate.1 Against any potential gain from pursuing optimal macroeconomic stabilisation, we need to place losses related to microeconomic inefficiencies. Specifically, those resulting from the inefficient allocation of traded goods across countries in which relative prices evolve, as a result of exchange rate fluctuations, with greater uncertainty.
