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Currency Areas and Monetary Coordination

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Author Info
Qing Liu
Shouyong Shi

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Abstract

In this paper we integrate the recent development in monetary theory with international finance, in order to examine the coordination between two currency areas in setting long-run inflation. The model determines the value of each currency and the size of each currency area without requiring buyers to use a particular currency to buy a country's goods. We show that the two countries inflate above the Friedman rule in a non-cooperative game. Coordination between the two areas reduces inflation to the Friedman rule, increases consumption, and improves welfare of both countries. This gain from coordination increases as the two areas become more integrated in trade. These results arise from the new features of the model, such as the deviations from the law of one price and the extensive margin of trade. To illustrate these new features, we show that introducing a direct tax on foreign holdings of a currency does not eliminate a country's incentive to inflate, while it does in traditional models.

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Publisher Info
Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-226.

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Length: 40 pages
Date of creation: 12 Apr 2006
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-226

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Related research
Keywords: Exchange rates; Currency areas; Coordination;

Other versions of this item:

Find related papers by JEL classification:
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General

This paper has been announced in the following NEP Reports:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Zhou, Ruilin, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Blackwell Publishing, vol. 64(2), pages 289-310, April. [Downloadable!] (restricted)
  2. 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. [Downloadable!]
    Other versions:
  3. Obstfeld, Maurice, 1998. " Open-Economy Macroeconomics: Developments in Theory and Policy," Scandinavian Journal of Economics, Blackwell Publishing, vol. 100(1), pages 247-75, March. [Downloadable!] (restricted)
    Other versions:
  4. Camera, Gabriele & Craig, Ben & Waller, Christopher J., 2004. "Currency competition in a fundamental model of money," Journal of International Economics, Elsevier, vol. 64(2), pages 521-544, December. [Downloadable!] (restricted)
    Other versions:
  5. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
    Other versions:
  6. Shouyong Shi, 1995. "Money and Prices: A Model of Search and Bargaining," Working Papers 916, Queen's University, Department of Economics.
    Other versions:
  7. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, vol. 83(1), pages 63-77, March. [Downloadable!] (restricted)
  8. Allen Head & Shouyong Shi, 2002. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers shouyong-03-01, University of Toronto, Department of Economics. [Downloadable!]
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  9. Thomas F. Cooley & Vincenzo Quadrini, 2003. "Common Currencies vs. Monetary Independence," Review of Economic Studies, Blackwell Publishing, vol. 70(4), pages 785-806, October. [Downloadable!] (restricted)
  10. Craig, Ben & Waller, C.J.Christopher J., 2004. "Dollarization and currency exchange," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 671-689, May. [Downloadable!] (restricted)
  11. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, vol. 18(3-4), pages 199-217, May. [Downloadable!] (restricted)
  12. Trejos, Alberto & Wright, Randall, 1995. "Search, Bargaining, Money, and Prices," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 118-41, February. [Downloadable!] (restricted)
  13. Kareken, John & Wallace, Neil, 1981. "On the Indeterminacy of Equilibrium Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 96(2), pages 207-22, May. [Downloadable!] (restricted)
  14. King, Robert G. & Wallace, Neil & Weber, Warren E., 1992. "Nonfundamental uncertainty and exchange rates," Journal of International Economics, Elsevier, vol. 32(1-2), pages 83-108, February. [Downloadable!] (restricted)
  15. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 865-90, October. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Shouyong Shi, 2006. "A Microfoundation of Monetary Economics," Working Papers tecipa-211, University of Toronto, Department of Economics. [Downloadable!]
  2. Benjamin Eden, 2006. "International Seigniorage Payments," Working Papers 0622, Department of Economics, Vanderbilt University. [Downloadable!]
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