Alan Blinder in the Wall St. Journal today urges his readers to “remember the two fundamental determinants of exchange rates: (1) productivity in different countries—so, other things equal, faster productivity growth should lead to a rising exchange rate; and (2) prices and wages in different countries—so lower inflation should lead to a rising exchange rate. Thus, for a currency union to succeed, its member nations need to register approximately equal productivity growth and approximately equal wage and price inflation.”
Really? There are at least two curiosities here, which I will label A and B.
(A) In standard usage, when an economist speaks of an exogenous shift that “should lead to a rising exchange rate,” he is applying a theory of the market exchange rate in a regime of floating exchange rates. Here Blinder is talking about a currency union, within which there “should” be no changes in exchange rates because there is a common currency. If factor x would cause an appreciation of Germany’s currency under floating rates but does not within the eurozone, that is not prima facie a failing of the currency union. Some other mechanism will provide the appropriate monetary adjustment, typically money flows into Germany from other countries.
(B) According to the standard Purchasing Power Parity theory of floating exchange rates, Blinder’s (2) is the only fundamental determinant of exchange rates. If (1) matters, it matters only so far as it works though (2). There is in fact no need for currency union members to have approximately equal productivity growth. Example: Panama and the US have been in a successful currency union for 107 years. Likewise Maine and Florida.
Can any of my economist friends explain to me why on earth Blinder thinks that you can’t have a currency union between countries with disparate productivity growth?