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A theory of the currency denomination of international trade

  • Philippe Bacchetta
  • Eric Van Wincoop

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 macroeconomic and policy implications. In this paper we solve for the optimal invoicing choice by integrating this microeconomic decision at the firm level into a general equilibrium open economy model. Strategic interactions between firms play a critical role in the analysis. We find that the less competition firms face in foreign markets, as reflected in market share and product differentiation, the more likely they will price in their own currency. 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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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 747.

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Date of creation: 2002
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Handle: RePEc:fip:fedgif:747
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  6. Philippe Bacchetta & Eric van Wincoop, 2000. "Trade Flows, Prices, and The Exchange Rate Regime," Working Papers 00.11, Swiss National Bank, Study Center Gerzensee.
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  8. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
  9. Jonathan McCarthy, 2000. "Pass-through of exchange rates and import prices to domestic inflation in some industrialized economies," Staff Reports 111, Federal Reserve Bank of New York.
  10. Philippe Bacchetta & Eric van Wincoop, 1998. "Does exchange rate stability increase trade and capital flows?," Research Paper 9818, Federal Reserve Bank of New York.
  11. Michael B. Devereux & Charles Engel & Peter E. Storgaard, 2002. "Endogenous Exchange Rate Pass-Through When Nominal Prices are Set in Advance," Working Papers 212002, Hong Kong Institute for Monetary Research.
  12. Philippe BACCHETTA & Eric VAN WINCOOP, 1999. "Does Exchange Rate Stability Increase Trade and Welfare ?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9917, Université de Lausanne, Faculté des HEC, DEEP.
  13. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  14. Philippe Bacchetta & Eric van Wincoop, 2002. "Why Do Consumer Prices React less than Import Prices to Exchange Rates ?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 02.18, Université de Lausanne, Faculté des HEC, DEEP.
  15. Hummels, David, 1999. "Toward a Geography of Trade Costs," GTAP Working Papers 1162, Center for Global Trade Analysis, Department of Agricultural Economics, Purdue University.
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  20. Corsetti, Giancarlo & Pesenti, Paolo, 2002. "International Dimensions of Optimal Monetary Policy," CEPR Discussion Papers 3349, C.E.P.R. Discussion Papers.
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  25. Cedric Tille, 2002. "On the distributional effects of exchange rate fluctuations," Staff Reports 146, Federal Reserve Bank of New York.
  26. Donnenfeld, S. & Zilcha, I., 1989. "Pricing Of Exports And Exchange Rate Uncertainty," Papers 12-89, Tel Aviv.
  27. Giancarlo Corsetti & Paolo Pesenti, 2002. "Self-Validating Optimum Currency Areas," NBER Working Papers 8783, National Bureau of Economic Research, Inc.
  28. Charles Engel, 2002. "The Responsiveness of Consumer Prices to Exchange Rates And the Implications for Exchange-Rate Policy: A Survey Of a Few Recent New Open-Economy..," NBER Working Papers 8725, National Bureau of Economic Research, Inc.
  29. G. Basevi & D. Cocchi & P. L. Lischi, 1985. "The Choice of Currency in the Foreign Trade of Italy," Working Papers 17, Dipartimento Scienze Economiche, Universita' di Bologna.
  30. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
  31. Feenstra, Robert C. & Gagnon, Joseph E. & Knetter, Michael M., 1996. "Market share and exchange rate pass-through in world automobile trade," Journal of International Economics, Elsevier, vol. 40(1-2), pages 187-207, February.
  32. Jose Manuel Campa & Linda S. Goldberg, 2002. "Exchange Rate Pass-Through into Import Prices: A Macro or Micro Phenomenon?," NBER Working Papers 8934, National Bureau of Economic Research, Inc.
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  35. Giovannini, Alberto, 1988. "Exchange rates and traded goods prices," Journal of International Economics, Elsevier, vol. 24(1-2), pages 45-68, February.
  36. 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.
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  41. repec:fth:eecero:26 is not listed on IDEAS
  42. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
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