Self-Validating Optimum Currency Areas

Giancarlo Corsetti and Paolo Pesenti

No 8783, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E5 F4 (search for similar items in EconPapers)
Date: 2002-02
New Economics Papers: this item is included in nep-ifn and nep-mon
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (97)

Downloads: (external link)
http://www.nber.org/papers/w8783.pdf (application/pdf)

Related works:
Working Paper: Self-Validating Optimum Currency Areas (2002)
Working Paper: Self-validating optimum currency areas (2002)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:8783

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w8783

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().