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Currency Areas and Monetary Coordination

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  • Qing Liu
  • Shouyong Shi

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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Bibliographic 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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Keywords: Exchange rates; Currency areas; Coordination;

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References

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  1. Camera, Gabriele & Craig, Ben & Waller, Christopher J., 2004. "Currency competition in a fundamental model of money," Journal of International Economics, Elsevier, Elsevier, vol. 64(2), pages 521-544, December.
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  3. Allen Head & Shouyong Shi, 2000. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers, Queen's University, Department of Economics 993, Queen's University, Department of Economics.
  4. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, American Economic Association, vol. 83(1), pages 63-77, March.
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  7. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research, Working Paper Series, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkele qt6412m5b7, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  8. Shi Shougong, 1995. "Money and Prices: A Model of Search and Bargaining," Journal of Economic Theory, Elsevier, Elsevier, vol. 67(2), pages 467-496, December.
  9. Thomas F. Cooley & Vincenzo Quadrini, 2003. "Common Currencies vs. Monetary Independence," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 785-806.
  10. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, Elsevier, vol. 18(3-4), pages 199-217, May.
  11. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers, Queen's University, Department of Economics 930, Queen's University, Department of Economics.
  12. Zhou, Ruilin, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 64(2), pages 289-310, April.
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Cited by:
  1. Bignon, Vincent & Breton, RĂ©gis & Rojas Breu, Mariana, 2013. "Currency Union with and without Banking Union," Economics Papers from University Paris Dauphine, Paris Dauphine University 123456789/12105, Paris Dauphine University.
  2. Shouyong Shi, 2006. "A Microfoundation of Monetary Economics," Working Papers, University of Toronto, Department of Economics tecipa-211, University of Toronto, Department of Economics.
  3. Benjamin Eden, 2007. "International Seigniorage Payments," 2007 Meeting Papers, Society for Economic Dynamics 54, Society for Economic Dynamics.
  4. Li, Yiting & Matsui, Akihiko, 2009. "A theory of international currency: Competition and discipline," Journal of the Japanese and International Economies, Elsevier, vol. 23(4), pages 407-426, December.

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