Self-Validating Optimum Currency Areas

Paolo Pesenti and Giancarlo Corsetti

No 3220, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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.

Keywords: Optimum currency areas; Monetary union; Optimal cyclical monetary policy; Nominal rigidities; Exchange rate pass-through (search for similar items in EconPapers)
JEL-codes: E50 F40 (search for similar items in EconPapers)
Date: 2002-02
New Economics Papers: this item is included in nep-ifn and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (89)

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Working Paper: Self-Validating Optimum Currency Areas (2002)
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