Uncertainty, Flexible Exchange Rates, and Agglomeration


WP/98/9-EAWP/98/9


.Uncertainty, Flexible Exchange Rates, and Agglomeration.
Luca Antonio Ricci


This paper shows that exchange rate variability can promote agglomeration of
economic activity. Under flexible exchange rates, firms located in large
markets tend to have lower variability of sales and higher expected profits,
which induces a self-reinforcing concentration of firms in large markets. This
outcome is independent of the usual forward and backward linkages formally
developed in the economic geography literature.


Empirical evidence on OECD countries is consistent with the prediction of the
model. First, the negative effect of country size on the variability of
industrial production (variability is higher for small countries) has been
stronger since the collapse of the Bretton Woods fixed rate system in 1973.
Second, for small countries, variability of exchange rates has a long-run
negative effect on net inward FDI flows, while for large countries the effect
is positive.


One important implication is that the creation of a currency area imposes a
negative externality on firms outside the area and fosters agglomeration in the
currency area. Given the peripherality of countries that may not participate
immediately in the EMU, a two-stage EMU may exacerbate the current uneven
regional development.