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Self-validating optimum currency areas

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Author Info
Giancarlo Corsetti
Paolo Pesenti

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Abstract

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. In our model, firms choose the optimal degree of exchange rate pass-through to export prices while accounting for expected monetary policies, and monetary authorities choose optimal policy rules while taking firms' pass-through as given. We show that there exist two equilibria, each of which defines a self-validating currency regime. In the first, firms preset prices in domestic currency and let prices in foreign currency 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 preset prices in consumer currency, and a monetary union is the optimal policy choice for all countries. Although a common currency helps synchronize business cycles across countries, flexible exchange rates deliver a superior welfare outcome.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 152.

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Date of creation: 2002
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Handle: RePEc:fip:fednsr:152

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Related research
Keywords: Monetary policy ; Monetary unions;

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This paper has been announced in the following NEP Reports: 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!]
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  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)
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  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)
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  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)
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  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)
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  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)
  15. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," Working Papers 042000, Hong Kong Institute for Monetary Research. [Downloadable!]
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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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