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The Optimal Currency Basket with Input Currency and Output Currency

  • Kang Shi

    (The Chinese University of Hong Kong)

  • Juanyi Xu

    (Hong Kong University of Science and Technology)

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    This paper explores the determination of the optimal currency basket in a small open economy general equilibrium model with sticky prices. In contrast to traditional literature, we focus on an economy with vertical trade, where one currency is used as the invoicing currency of imported intermediate goods and is called the "input currency", while the other currency is used for the invoicing of exported finished goods and is called the "output currency". We find that in the optimal currency basket the weight between the input currency and the output currency depends critically on the structure of vertical trade. Moreover, we show that if a country decides to choose a single-currency peg, then the choice of pegging currency depends mainly on how other economies respond to external exchange rate fluctuations. In a sense, our paper provides a case for the Chinese RMB peg in some East Asian economies, given the importance of the RMB as an input currency.

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    Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 172008.

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    Length: 27 pages
    Date of creation: Sep 2008
    Date of revision:
    Handle: RePEc:hkm:wpaper:172008
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