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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
Date of revision:
Handle: RePEc:nbr:nberwo:8783
Note: IFM
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  17. Jeffrey A. Frankel & Andrew K. Rose, 1996. "The Endogeneity of the Optimum Currency Area Criteria," NBER Working Papers 5700, National Bureau of Economic Research, Inc.
  18. Neumeyer, Pablo Andres, 1998. "Currencies and the Allocation of Risk: The Welfare Effects of a Monetary Union," American Economic Review, American Economic Association, vol. 88(1), pages 246-59, March.
  19. 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.
  20. George S. Tavlas, 1993. "The ‘New’ Theory of Optimum Currency Areas," The World Economy, Wiley Blackwell, vol. 16(6), pages 663-685, November.
  21. 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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