DP3220 Self-Validating Optimum Currency Areas

Author(s): Giancarlo Corsetti, Paolo Pesenti
Publication Date: February 2002
Keyword(s): exchange rate pass-through, monetary union, nominal rigidities, optimal cyclical monetary policy, optimum currency areas
JEL(s): E50, F40
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3220

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.