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Self-Validating Optimum Currency Areas

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  • Corsetti, Giancarlo
  • Pesenti, Paolo

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

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References

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  1. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May.
  2. Frankel, Jeffrey A & Rose, Andrew K, 1996. "The Endogeneity of the Optimum Currency Area Criteria," CEPR Discussion Papers 1473, C.E.P.R. Discussion Papers.
  3. Maurice Obstfeld and Kenneth Rogoff., 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research (CIDER) Working Papers C01-120, University of California at Berkeley.
  4. Jacques Mélitz, 1996. "The theory of optimum currency areas, trade adjustment, and trade," Open Economies Review, Springer, vol. 7(2), pages 99-116, April.
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  7. Giancarlo Corsetti & Paolo Pesenti, 2001. "International Dimensions of Optimal Monetary Policy," NBER Working Papers 8230, National Bureau of Economic Research, Inc.
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  9. Barry Eichengreen., 1990. "One Money for Europe? Lessons from the US Currency Union," Economics Working Papers 90-132, University of California at Berkeley.
  10. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
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  12. 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.
  13. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  14. Eichengreen, B., 1992. "Should the Maastricht Treaty be Saved?," Princeton Studies in International Economics 74, International Economics Section, Departement of Economics Princeton University,.
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  17. 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.
  18. Maurice Obstfeld & Kenneth Rogoff, 2000. "Do We Really Need a New International Monetary Compact?," NBER Working Papers 7864, National Bureau of Economic Research, Inc.
  19. 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.
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