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Self-Validating Optimum Currency Areas

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Author Info
Corsetti, Giancarlo
Pesenti, Paolo

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Abstract

In this Paper we show that a currency area can be a self-validating optimal policy regime, even when monetary unification does not foster real economic integration and intra-industry trade. This is because profit-maximizing producers in a currency area adopt endogenous pricing strategies that make exchange rate fluctuations highly costly in welfare terms. In our model exporters choose the degree of exchange rate pass-through onto export prices given monetary policy rules, and monetary authorities choose optimal policy rules taking firms' pass-through as given. We show that there exist two equilibria, which define two self-validating currency regimes. In the first, firms preset prices in domestic currency only, and let foreign-currency prices to be determined by the law of one price. Optimal policy rules then target the domestic output gap and floating exchange rates support the flex-price allocation. In the second equilibrium firms optimally preset prices in local currency, and a monetary union is the optimal policy choice for all countries. Although business cycles are more synchronized with a common currency, flexible exchange rates are superior in terms of welfare.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3220.

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Date of creation: Feb 2002
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Handle: RePEc:cpr:ceprdp:3220

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Related research
Keywords: exchange rate pass-through monetary union nominal rigidities optimal cyclical monetary policy optimum currency areas

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Find related papers by JEL classification:
E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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References listed on IDEAS
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  1. Alberto Alesina & Robert J. Barro, 2002. "Currency Unions," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 409-436, May. [Downloadable!] (restricted)
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  2. Eichengreen, B., 1992. "Should the Maastricht Treaty be Saved?," Princeton Studies in International Economics 74, International Economics Section, Departement of Economics Princeton University,.
  3. Philippe Bacchetta & Eric van Wincoop, 2001. "A Theory of the Currency Denomination of International Trade," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 01.13, Université de Lausanne, Faculté des HEC, DEEP. [Downloadable!]
    Other versions:
  4. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May. [Downloadable!] (restricted)
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  5. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February. [Downloadable!] (restricted)
    Other versions:
  6. Jacques Mélitz, 1996. "The theory of optimum currency areas, trade adjustment, and trade," Open Economies Review, Springer, vol. 7(2), pages 99-116, April. [Downloadable!] (restricted)
    Other versions:
  7. Frankel, Jeffrey A & Rose, Andrew K, 1998. "The Endogeneity of the Optimum Currency Area Criteria," Economic Journal, Royal Economic Society, vol. 108(449), pages 1009-25, July. [Downloadable!] (restricted)
    Other versions:
  8. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  9. Andrew K. Rose & Charles Engel, 2000. "Currency Unions and International Integration," NBER Working Papers 7872, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  10. Maurice Obstfeld & Kenneth Rogoff, 2002. "Global Implications Of Self-Oriented National Monetary Rules," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 503-535, May. [Downloadable!] (restricted)
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  11. Giancarlo Corsetti & Paolo Pesenti, 2001. "International dimensions of optimal monetary policy," Staff Reports 124, Federal Reserve Bank of New York. [Downloadable!]
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  12. Dowd, Kevin & Greenaway, David, 1993. "Currency Competition, Network Externalities and Switching Costs: Towards an Alternative View of Optimum Currency Areas," Economic Journal, Royal Economic Society, vol. 103(420), pages 1180-89, September. [Downloadable!] (restricted)
  13. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May. [Downloadable!] (restricted)
  14. Maurice Obstfeld & Kenneth Rogoff, 2000. "Do We Really Need a New International Monetary Compact?," NBER Working Papers 7864, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "The Need for International Policy Coordination: What's Old, What's New, What's Yet to Come?," NBER Working Papers 8765, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  17. Devereux, Michael B & Engel, Charles M, 2000. "Monetary Policy In The Open Economy Revisited: Price Setting Rules And Exchange Rate Flexibility," CEPR Discussion Papers 2454, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  18. Neumeyer, Pablo Andres, 1998. "Currencies and the Allocation of Risk: The Welfare Effects of a Monetary Union," American Economic Review, American Economic Association, vol. 88(1), pages 246-59, March. [Downloadable!] (restricted)
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  19. Michael B. Devereux & Charles Engel, 2001. "Endogenous Currency of Price Setting in a Dynamic Open Economy Model," NBER Working Papers 8559, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  20. Barry Eichengreen., 1990. "One Money for Europe? Lessons from the US Currency Union," Economics Working Papers 90-132, University of California at Berkeley.
  21. Bayoumi, T. & Eichengreen, B., 1994. "One Money or Many? Analysing the Prospects for Monetary Unification in Various Parts of the World," Princeton Studies in International Economics 76, International Economics Section, Departement of Economics Princeton University,.
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