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Currency Areas and Monetary Coordination

  • Qing Liu
  • Shouyong Shi

In this paper we integrate the recent development in monetary theory with international finance, in order to examine the coordination between two currency areas in setting long-run inflation. The model determines the value of each currency and the size of each currency area without requiring buyers to use a particular currency to buy a country's goods. We show that the two countries inflate above the Friedman rule in a non-cooperative game. Coordination between the two areas reduces inflation to the Friedman rule, increases consumption, and improves welfare of both countries. This gain from coordination increases as the two areas become more integrated in trade. These results arise from the new features of the model, such as the deviations from the law of one price and the extensive margin of trade. To illustrate these new features, we show that introducing a direct tax on foreign holdings of a currency does not eliminate a country's incentive to inflate, while it does in traditional models.

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Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 575.

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Date of creation: 2005
Date of revision:
Handle: RePEc:red:sed005:575
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Thomas F. Cooley & Vincenzo Quadrini, 2003. "Common Currencies vs. Monetary Independence," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 785-806.
  2. Maurice Obstfeld & Kenneth Rogoff, 2003. "Global Implications of Self-Oriented National Monetary Rules," Macroeconomics 0303018, EconWPA.
  3. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
  4. Allen Head & Shouyong Shi, 2002. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers shouyong-03-01, University of Toronto, Department of Economics.
  5. Camera, Gabriele & Craig, Ben & Waller, Christopher J., 2004. "Currency competition in a fundamental model of money," Journal of International Economics, Elsevier, vol. 64(2), pages 521-544, December.
  6. John Kareken & Neil Wallace, 1981. "On the Indeterminacy of Equilibrium Exchange Rates," The Quarterly Journal of Economics, Oxford University Press, vol. 96(2), pages 207-222.
  7. Maurice Obstfeld, 1997. "Open-Economy Macroeconomics: Developments in Theory and Policy," Working Papers 958, Queen's University, Department of Economics.
  8. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 865-90, October.
  9. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, vol. 18(3-4), pages 199-217, May.
  10. Craig, Ben & Waller, C.J.Christopher J., 2004. "Dollarization and currency exchange," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 671-689, May.
  11. Ruilin Zhou, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Oxford University Press, vol. 64(2), pages 289-310.
  12. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, vol. 83(1), pages 63-77, March.
  13. Shouyong Shi, 1995. "Money and Prices: A Model of Search and Bargaining," Working Papers 916, Queen's University, Department of Economics.
  14. Trejos, Alberto & Wright, Randall, 1995. "Search, Bargaining, Money, and Prices," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 118-41, February.
  15. King, Robert G. & Wallace, Neil & Weber, Warren E., 1992. "Nonfundamental uncertainty and exchange rates," Journal of International Economics, Elsevier, vol. 32(1-2), pages 83-108, February.
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