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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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  1. Philippe Bacchetta & Eric van Wincoop, 2000. "Trade Flows, Prices, and The Exchange Rate Regime," Working Papers 00.11, Swiss National Bank, Study Center Gerzensee.
  2. Pinelopi Koujianou Goldberg & Michael M. Knetter, 1997. "Goods Prices and Exchange Rates: What Have We Learned?," Journal of Economic Literature, American Economic Association, vol. 35(3), pages 1243-1272, September.
  3. Rey, Hélène, 1999. "International Trade and Currency Exchange," CEPR Discussion Papers 2226, C.E.P.R. Discussion Papers.
  4. Feenstra, R.C. & Gagnon, J.E. & Knetter, M.M., 1993. "Market Share and Exchange Rate Pass-Through in World Automobile Trade," Papers 93-14, California Davis - Institute of Governmental Affairs.
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  7. Giancarlo Corsetti & Paolo Pesenti, 2001. "International dimensions of optimal monetary policy," Staff Reports 124, Federal Reserve Bank of New York.
  8. Bacchetta, Philippe & van Wincoop, Eric, 2003. "Why do Consumer Prices React Less than Import Prices to Exchange Rates?," CEPR Discussion Papers 3702, C.E.P.R. Discussion Papers.
  9. Corsetti, Giancarlo & Pesenti, Paolo, 2002. "Self-Validating Optimum Currency Areas," CEPR Discussion Papers 3220, C.E.P.R. Discussion Papers.
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  14. Michael B. Devereux & Charles Engel & Peter E. Storgaard, 2003. "Endogenous Exchange Rate Pass-through when Nominal Prices are Set in Advance," NBER Working Papers 9543, National Bureau of Economic Research, Inc.
  15. 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.
  16. Hummels, David, 1999. "Toward a Geography of Trade Costs," GTAP Working Papers 1162, Center for Global Trade Analysis, Department of Agricultural Economics, Purdue University.
  17. 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.
  18. Philippe Bacchetta & Eric van Wincoop, 1998. "Does exchange rate stability increase trade and capital flows?," Research Paper 9818, Federal Reserve Bank of New York.
  19. Alan Sutherland, 2002. "Incomplete Pass-Through and the Welfare Effects of Exchange Rate Variability," Discussion Paper Series, Department of Economics 200212, Department of Economics, University of St. Andrews.
  20. Giovannini, Alberto, 1988. "Exchange rates and traded goods prices," Journal of International Economics, Elsevier, vol. 24(1-2), pages 45-68, February.
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  22. Maurice Obstfeld, 2002. "Exchange Rates and Adjustment: Perspectives from the New Open Economy Macroeconomics," NBER Working Papers 9118, National Bureau of Economic Research, Inc.
  23. 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.
  24. Jonathan McCarthy, 2007. "Pass-Through of Exchange Rates and Import Prices to Domestic Inflation in Some Industrialized Economies," Eastern Economic Journal, Eastern Economic Association, vol. 33(4), pages 511-537, Fall.
  25. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  26. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  27. Paul Klemperer & Margaret Meyer, 1986. "Price Competition vs. Quantity Competition: The Role of Uncertainty," RAND Journal of Economics, The RAND Corporation, vol. 17(4), pages 618-638, Winter.
  28. Bekx, P. & Directorate General II - Economic and Financial Affairs, 1998. "The Implications of the Introduction of the Euro for Non-EU Countries," Papers 26, Commission of the EEC - Euro Papers.
  29. Hartmann, Philipp, 1998. "The Currency Denomination of World Trade after European Monetary Union," Journal of the Japanese and International Economies, Elsevier, vol. 12(4), pages 424-454, December.
  30. Eric van Wincoop, 1998. "How big are potential welfare gains from international risksharing?," Staff Reports 37, Federal Reserve Bank of New York.
  31. Jean-Marie Viaene & Casper Vries, 1992. "On the design of invoicing practices in international trade," Open Economies Review, Springer, vol. 3(2), pages 133-142, June.
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  34. Charles Engel, 2003. "Expenditure Switching and Exchange-Rate Policy," NBER Chapters, in: NBER Macroeconomics Annual 2002, Volume 17, pages 231-300 National Bureau of Economic Research, Inc.
  35. 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.
  36. Giorgio Basevi & Daniela Cocchi & Pier Luigi Lischi, 1985. "The Choice of Currency in the Foreign Trade of Italy," Working Papers 17, Dipartimento Scienze Economiche, Universita' di Bologna.
  37. 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.
  38. Johnson, Martin & Pick, Daniel, 1997. "Currency Quandary: The Choice of Invoicing Currency under Exchange-Rate Uncertainty," Review of International Economics, Wiley Blackwell, vol. 5(1), pages 118-28, February.
  39. Peter Hooper & Karen Johnson & Jaime Marquez, 1998. "Trade elasticities for G-7 countries," International Finance Discussion Papers 609, Board of Governors of the Federal Reserve System (U.S.).
  40. 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.
  41. Friberg, Richard, 1998. "In which currency should exporters set their prices?," Journal of International Economics, Elsevier, vol. 45(1), pages 59-76, June.
  42. Bacchetta, Philippe & van Wincoop, Eric, 2002. "A Theory of Currency Denomination of International Trade," CEPR Discussion Papers 3120, C.E.P.R. Discussion Papers.
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