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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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File URL: http://www.economics.utoronto.ca/public/workingPapers/tecipa-226-1.pdf
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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-226.

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Length: 40 pages
Date of creation: 12 Apr 2006
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-226
Contact details of provider: Postal: 150 St. George Street, Toronto, Ontario
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  1. Kareken, John & Wallace, Neil, 1981. "On the Indeterminacy of Equilibrium Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 96(2), pages 207-22, May.
  2. Thomas F. Cooley & Vincenzo Quadrini, 2003. "Common Currencies vs. Monetary Independence," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 785-806.
  3. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research, Working Paper Series qt6412m5b7, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  4. 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.
  5. Maurice Obstfeld, 1997. "Open-Economy Macroeconomics: Developments in Theory and Policy," Working Papers 958, Queen's University, Department of Economics.
  6. Shouyong Shi, 1995. "Money and Prices: A Model of Search and Bargaining," Working Papers 916, Queen's University, Department of Economics.
  7. Allen Head & Shouyong Shi, 2000. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers 993, Queen's University, Department of Economics.
  8. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, vol. 18(3-4), pages 199-217, May.
  9. 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.
  10. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
  11. Gabriele Camera & Ben Craig & Christopher J. Waller, 2003. "Currency competition in a fundamental model of money," Working Paper 0311, Federal Reserve Bank of Cleveland.
  12. Zhou, Ruilin, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Wiley Blackwell, vol. 64(2), pages 289-310, April.
  13. 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.
  14. 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.
  15. Craig, Ben & Waller, C.J.Christopher J., 2004. "Dollarization and currency exchange," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 671-689, May.
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