Self-Validating Optimum Currency Areas

26 Pages Posted: 14 Feb 2002 Last revised: 26 Oct 2010

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS); University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Paolo A. Pesenti

Federal Reserve Bank of New York; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2002

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.

Suggested Citation

Corsetti, Giancarlo and Pesenti, Paolo A., Self-Validating Optimum Currency Areas (February 2002). NBER Working Paper No. w8783. Available at SSRN: https://ssrn.com/abstract=300745

Giancarlo Corsetti

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

University of Rome III - Department of Economics ( email )

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Rome, 00154
Italy
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+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Paolo A. Pesenti (Contact Author)

Federal Reserve Bank of New York ( email )

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New York, NY 10045
United States
212-720-5493 (Phone)
212-720-6831 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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