Self-validating optimum currency areas

Giancarlo Corsetti and Paolo Pesenti

No 152, Staff Reports from Federal Reserve Bank of New York

Abstract: 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. In our model, firms choose the optimal degree of exchange rate pass-through to export prices while accounting for expected monetary policies, and monetary authorities choose optimal policy rules while taking firms' pass-through as given. We show that there exist two equilibria, each of which defines a self-validating currency regime. In the first, firms preset prices in domestic currency and let prices in foreign currency 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 preset prices in consumer currency, and a monetary union is the optimal policy choice for all countries. Although a common currency helps synchronize business cycles across countries, flexible exchange rates deliver a superior welfare outcome.

Keywords: Monetary policy; monetary unions (search for similar items in EconPapers)
Date: 2002
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
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Citations: View citations in EconPapers (70)

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