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A Theory of the Currency Denomination of International Trade

  • Philippe Bacchetta

    ()

    (University of Lausanne, Studienzentrum Gerzensee and CEPR)

  • Eric van Wincoop

    ()

    (University of Virginia)

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 implications for exchange rate pass-through to import prices, the level of trade and net capital flows, and optimal monetary and exchange rate policy. While the literature has exogenously assumed in which currencies goods are priced, in this paper we solve for the equilibrium optimal pricing strategies of firms. We find that the higher the market share of an exporting country in an industry, and the more differentiated its goods, the more likely its exporters will price in the exporter's currency. Country size and the cyclicality of real wages play a role as well, but are empirically less important. 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 Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 01.07.

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Length: 43 pages
Date of creation: Dec 2001
Date of revision:
Handle: RePEc:szg:worpap:0107
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  1. Jonathan McCarthy, 2000. "Pass-through of exchange rates and import prices to domestic inflation in some industrialized economies," Staff Reports 111, Federal Reserve Bank of New York.
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  13. Eric van Wincoop & Philippe Bacchetta, 2000. "Does Exchange-Rate Stability Increase Trade and Welfare?," American Economic Review, American Economic Association, vol. 90(5), pages 1093-1109, December.
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  25. Maurice Obstfeld, 2001. "International Macroeconomics: Beyond the Mundell-Fleming Model," NBER Working Papers 8369, National Bureau of Economic Research, Inc.
  26. Bacchetta, Philippe & van Wincoop, Eric, 1998. "Does Exchange Rate Stability Increase Trade and Capital Flows?," CEPR Discussion Papers 1962, C.E.P.R. Discussion Papers.
  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.
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  29. Friberg, Richard, 1998. "In which currency should exporters set their prices?," Journal of International Economics, Elsevier, vol. 45(1), pages 59-76, June.
  30. Bacchetta, Philippe & van Wincoop, Eric, 2002. "A Theory of Currency Denomination of International Trade," CEPR Discussion Papers 3120, C.E.P.R. Discussion Papers.
  31. Rey, Helene, 2001. "International Trade and Currency Exchange," Review of Economic Studies, Wiley Blackwell, vol. 68(2), pages 443-64, April.
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  35. Philippe Bacchetta & Eric van Wincoop, 2000. "Trade Flows, Prices, and The Exchange Rate Regime," Working Papers 00.11, Swiss National Bank, Study Center Gerzensee.
  36. 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.
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  41. 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.
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