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Policy Coordination
Structural Interdependence
• Structural interdependence is the reason
that policymakers might consider the joint
determination of economic policies.
• Structural interdependence refers to the
interconnectedness of nations’ markets for
goods and services, financial markets and
payments systems.
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International Policy Externalities
• Structural interdependences can results in
international policy externalities: a benefit or cost
for one nation’s economy owing to a policy
undertaken in another economy.
• A locomotive effect occurs when an increase in
real income in one economy spurs an increase in
real income in another.
• A beggar-thy-neighbor effect occurs when a policy
action benefits the residents of the home country
at the expense of residents in another nation.
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International Policy Cooperation
and Coordination
• There are two ways that nations may work
together to achieve their economic objectives.
• International Policy Cooperation is the adoption
of institutions and procedures by which
policymakers can inform each other of their
objectives and share data.
• International Policy Coordination is the joint
determination of economic policies within a group
of nations, intended to benefit the whole.
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Potential Benefits of Coordination
1. Take account of and minimize policy
externalities
2. Achieve a larger number of policy
objectives with available instruments
3. Policymakers may present a “united front”
in the face of home political pressures that
could push them to adopt harmful policies.
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Potential Drawbacks to
Policy Coordination
1. Must sacrifice or forego some domestic
interests
2. Must trust that counterparts are willing to
make sacrifices
3. Coordinated policies may have negative
consequences such as higher inflation
(e.g., Bonn Summit of 1978)
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Monetary Unions
• An extreme type of coordination is for a
nation to give up its own currency and
adopt a currency common to it and a
coalition of other nations.
• That is, form a monetary union.
• For a monetary union to succeed, the
coalition must represent an optimal
currency area.
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Optimal Currency Area
• The theory of optimal currency areas is a means of
determining the size of a geographic area within
which residents’ welfare is greater if their
governments fix exchange rates or adopt a
common currency.
• An optimal currency area is on in which labor is
sufficiently mobile to permit speedy adjustments
to payments imbalances and regional
unemployment so that exchange rates can be fixed
or a common currency adopted.
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Exchange Rate Target Zones
• A target zone is a “intermediate” approach to
exchange rate management that limits exchange
rate volatility while still permitting some variation
in countries currency values.
• Specifically, a target zone is a range of permitted
exchange rate variation between upper and lower
exchange rate bands that a central bank defends by
purchasing or selling foreign exchange reserves.
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