Adjustment Costs, Optimal Currency Areas, and International Reserves

Abstract

When a country faces a disequilibrium in its Balance of Payments, it must make several choices. Paramount among them are (a) the choice (or the optimal balance) between adjustment to the disturbance and financing of the disequilibrium by the use of international monetary reserves, and (b) the choice of the optimal adjustment technique. Several factors relating to the internal as well as external position of the country have an important bearing on these decisions. This paper is concerned with the economic costs of adjustment on the assumption that the rational policy-maker would select the course of action that minimises these costs. With this in mind, the second choice listed above has implications for the optimum currency area problem, for it provides a criterion for the least cost policy to rectify external imbalances. The next two sections develop criteria for measuring the cost of adjustment and apply them to the determination of optimum currency areas. Some rough empirical estimates are also provided, with data pertaining to the 1960s. The final section is devoted to the choice between adjustment and financing, and its implications for optimal international reserves.