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A Theory of the Currency Denomination of International Trade

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  • Philippe Bacchetta
  • Eric van Wincoop

Abstract

Nominal rigidities due to menu costs have become a standard element in closed economy macroeconomic modeling. The 'New Open Economy Macroeconomics' literature has investigated the implications of nominal rigidities in an open economy context and found that the currency in which prices are set has significant implications for exchange rate pass-through to import prices, the level of trade and net capital flows, and optimal monetary and exchange rate policy. While the literature has exogenously assumed in which currencies goods are priced, in this paper we solve for the equilibrium optimal pricing strategies of firms. We find that the higher the market share of an exporting country in an industry, and the more differentiated its goods, the more likely its exporters will price in the exporter's currency. Country size and the cyclicality of real wages play a role as well, but are empirically less important. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9039.

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Date of creation: Jul 2002
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Publication status: published as Bacchetta, Philippe and Eric van Wincoop. "A Theory Of The Currency Denomination Of International Trade," Journal of International Economics, 2005, 67(2,Dec), 295-319
Handle: RePEc:nbr:nberwo:9039

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