A Theory of the Currency Denomination of International Trade

43 Pages Posted: 8 Jul 2002 Last revised: 28 Oct 2010

See all articles by Philippe Bacchetta

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Eric van Wincoop

University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: July 2002

Abstract

Nominal rigidities due to menu costs have become a standard element in closed economy macroeconomic modeling. The 'New Open Economy Macroeconomics' literature has investigated the implications of nominal rigidities in an open economy context and found that the currency in which prices are set has significant implications for exchange rate pass-through to import prices, the level of trade and net capital flows, and optimal monetary and exchange rate policy. While the literature has exogenously assumed in which currencies goods are priced, in this paper we solve for the equilibrium optimal pricing strategies of firms. We find that the higher the market share of an exporting country in an industry, and the more differentiated its goods, the more likely its exporters will price in the exporter's currency. Country size and the cyclicality of real wages play a role as well, but are empirically less important. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.

Suggested Citation

Bacchetta, Philippe and van Wincoop, Eric, A Theory of the Currency Denomination of International Trade (July 2002). NBER Working Paper No. w9039, Available at SSRN: https://ssrn.com/abstract=318464

Philippe Bacchetta

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

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CH-1211 Geneva 4
Switzerland

Eric Van Wincoop (Contact Author)

University of Virginia - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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United States

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