Working Paper: CEPR ID: DP3220
Authors: Giancarlo Corsetti; Paolo Pesenti
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.
Keywords: exchange rate passthrough; monetary union; nominal rigidities; optimal cyclical monetary policy; optimum currency areas
JEL Codes: E50; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary union adoption (F36) | self-validating equilibria (C62) |
| self-validating equilibria (C62) | firms adjust pricing strategies (L11) |
| firms adjust pricing strategies (L11) | minimize welfare costs associated with exchange rate fluctuations (F16) |
| Monetary union adoption (F36) | correlation of national outputs increases (O47) |
| correlation of national outputs increases (O47) | firms' pricing behaviors limit incentives for independent stabilization strategies (L11) |
| Optimal monetary union is Pareto inferior to flexible exchange rate arrangement (F36) | nuanced view of trade-offs (F12) |