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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. Daniels and VanHoose Policy Coordination 2 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. Daniels and VanHoose Policy Coordination 3 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. Daniels and VanHoose Policy Coordination 4 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. Daniels and VanHoose Policy Coordination 5 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) Daniels and VanHoose Policy Coordination 6 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. Daniels and VanHoose Policy Coordination 7 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. Daniels and VanHoose Policy Coordination 8 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. Daniels and VanHoose Policy Coordination 9