Edited by M. A.B. Siddique
Chapter 3: Preferential Trade Agreements and Exchange Rate Regimes
Larry A. Sjaastad INTRODUCTION In the written version of a lecture that Robert Mundell (Mundell 2000) delivered at the Universidad del CEMA in Buenos Aires, Argentina, on 17 April 2000, he declares in Part 6 of his lecture: What is the relation between free trade areas or customs unions and the exchange rate system? Put somewhat diﬀerently, is it possible to achieve the full beneﬁts of a free trade area and at the same time have exchange rates that ﬂuctuate? I will make the argument that free trade areas and currency areas (zones of ﬁxed exchange rates) reinforce one another. [He goes on to say that] uncertainty over exchange rates aﬀects trade directly because it aﬀects proﬁt margins and indirectly because it misdirects investment. Small changes in exchange rates can completely wipe out expected proﬁts.1 In this chapter I intend to make points somewhat similar to those of Mundell, but in a rather diﬀerent context.2 My main point is that free (or preferential) trading arrangements are best undertaken among economies that constitute an optimum currency area. Mundell’s analysis in his seminal article on optimum currency areas in 1961 was in the context of the Bretton Woods international monetary system, in which exchange rates among major (and many minor) currencies were ﬁxed. His conclusion was that an optimum currency area is one in which there was free mobility of factors. Accordingly, the USA and Australia are optimum currency areas, but the euro zone may...
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