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Self-Validating Optimum Currency Areas

  • Giancarlo Corsetti
  • Paolo Pesenti

In this paper we show that a currency area can be a self-validating optimal policy regime, even when monetary unification does not foster real economic integration and intra-industry trade. This is because profit-maximizing producers in a currency area adopt endogenous pricing strategies that make exchange rate fluctuations highly costly in welfare terms. In our model exporters choose the degree of exchange rate pass-through onto export prices given monetary policy rules, and monetary authorities choose optimal policy rules taking firms' pass-through as given. We show that there exist two equilibria, which define two self-validating currency regimes. In the first, firms preset prices in domestic currency only, and let foreign-currency prices to be determined by the law of one price. Optimal policy rules then target the domestic output gap and floating exchange rates support the flex-price allocation. In the second equilibrium firms optimally preset prices in local currency, and a monetary union is the optimal policy choice for all countries. Although business cycles are more synchronized with a common currency, flexible exchange rates are superior in terms of welfare.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8783.

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Date of creation: Feb 2002
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Handle: RePEc:nbr:nberwo:8783
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  1. Frankel, Jeffrey A & Rose, Andrew K, 1998. "The Endogeneity of the Optimum Currency Area Criteria," Economic Journal, Royal Economic Society, vol. 108(449), pages 1009-25, July.
  2. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May.
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  4. Neumeyer, P.A., 1995. "Currencies and the Allocation of Risk: The Welfare Effect of a Monetary Union," DELTA Working Papers 95-27, DELTA (Ecole normale supérieure).
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  6. Dowd, Kevin & Greenaway, David, 1993. "Currency Competition, Network Externalities and Switching Costs: Towards an Alternative View of Optimum Currency Areas," Economic Journal, Royal Economic Society, vol. 103(420), pages 1180-89, September.
  7. Eichengreen, B., 1992. "Should the Maastricht Treaty be Saved?," Princeton Studies in International Economics 74, International Economics Section, Departement of Economics Princeton University,.
  8. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
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  10. Corsetti, Giancarlo & Pesenti, Paolo, 2005. "International dimensions of optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 281-305, March.
  11. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Orientated National Monetary Rules," CEPR Discussion Papers 2856, C.E.P.R. Discussion Papers.
  12. Michael B. Devereux & Charles Engel, 2003. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 765-783.
  13. Jacques Mélitz, 1996. "The theory of optimum currency areas, trade adjustment, and trade," Open Economies Review, Springer, vol. 7(2), pages 99-116, April.
  14. Rose, Andrew K & Engel, Charles, 2002. "Currency Unions and International Integration," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(4), pages 1067-89, November.
  15. Barry Eichengreen., 1990. "One Money for Europe? Lessons from the US Currency Union," Economics Working Papers 90-132, University of California at Berkeley.
  16. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  17. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
  18. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "The Need for International Policy Coordination: What's Old, What's New, What's Yet to Come?," NBER Working Papers 8765, National Bureau of Economic Research, Inc.
  19. George S. Tavlas, 1993. "The ‘New’ Theory of Optimum Currency Areas," The World Economy, Wiley Blackwell, vol. 16(6), pages 663-685, November.
  20. Bayoumi, T. & Eichengreen, B., 1994. "One Money or Many? Analysing the Prospects for Monetary Unification in Various Parts of the World," Princeton Studies in International Economics 76, International Economics Section, Departement of Economics Princeton University,.
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  22. Devereux, Michael B & Engel, Charles M, 2000. "Monetary Policy In The Open Economy Revisited: Price Setting Rules And Exchange Rate Flexibility," CEPR Discussion Papers 2454, C.E.P.R. Discussion Papers.
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