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The Optimal Currency Basket with Input Currency and Output Currency

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  • Kang Shi

    (The Chinese University of Hong Kong)

  • Juanyi Xu

    (Hong Kong University of Science and Technology)

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    Abstract

    This paper explores the determination of the optimal currency basket in a small open economy general equilibrium model with sticky prices. In contrast to traditional literature, we focus on an economy with vertical trade, where one currency is used as the invoicing currency of imported intermediate goods and is called the "input currency", while the other currency is used for the invoicing of exported finished goods and is called the "output currency". We find that in the optimal currency basket the weight between the input currency and the output currency depends critically on the structure of vertical trade. Moreover, we show that if a country decides to choose a single-currency peg, then the choice of pegging currency depends mainly on how other economies respond to external exchange rate fluctuations. In a sense, our paper provides a case for the Chinese RMB peg in some East Asian economies, given the importance of the RMB as an input currency.

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    Bibliographic Info

    Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 172008.

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    Length: 27 pages
    Date of creation: Sep 2008
    Date of revision:
    Handle: RePEc:hkm:wpaper:172008

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    Related research

    Keywords: Input Currency; Output Currency; Currency Basket Peg; Welfare;

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    References

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    1. Cook, David & Devereux, Michael B., 2006. "External currency pricing and the East Asian crisis," Journal of International Economics, Elsevier, vol. 69(1), pages 37-63, June.
    2. Eva Ortega & Nooman Rebei, 2006. "The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy," Working Papers 06-12, Bank of Canada.
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    7. David Hummels & Dana Rapoport & Kei-Mu Yi, 1998. "Vertical specialization and the changing nature of world trade," Economic Policy Review, Federal Reserve Bank of New York, issue Jun, pages 79-99.
    8. Slavi T. Slavov, 2005. "Should small open economies in East Asia put all their eggs in one basket: the role of balance sheet effects," International Finance 0501001, EconWPA.
    9. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
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    12. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.
    13. Philip R. Lane & Michael B. Devereux,Juanyi Xu, 2005. "Exchange Rates and Monetary Policy in Emerging Market Economies," The Institute for International Integration Studies Discussion Paper Series iiisdp036, IIIS.
    14. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
    15. Teo, Wing Leong, 2009. "Should East Asia's currencies be pegged to the yen? The role of invoice currency," Journal of the Japanese and International Economies, Elsevier, vol. 23(3), pages 283-308, September.
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    17. Kei-Mu Yi, 2000. "Can vertical specialization explain the growth of world trade?," Staff Reports 96, Federal Reserve Bank of New York.
    18. Robert C. Feenstra & Gordon H. Hanson, 2004. "Intermediaries in Entrepot Trade: Hong Kong Re-Exports of Chinese Goods," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 13(1), pages 3-35, 03.
    19. Kang Shi & Juanyi Xu, 2007. "Optimal Monetary Policy with Vertical Production and Trade," Review of International Economics, Wiley Blackwell, vol. 15(3), pages 514-537, 08.
    20. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1999. "Monetary policy shocks: What have we learned and to what end?," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 2, pages 65-148 Elsevier.
    21. Huang, Kevin X.D. & Liu, Zheng, 2006. "Sellers' local currency pricing or buyers' local currency pricing: does it matter for international welfare analysis?," Journal of Economic Dynamics and Control, Elsevier, vol. 30(7), pages 1183-1213, July.
    22. Basu, Susanto & Fernald, John G, 1997. "Returns to Scale in U.S. Production: Estimates and Implications," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 249-83, April.
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