Working Paper: NBER ID: w8783
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: No keywords provided
JEL Codes: E5; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary union (F36) | national output correlation (E23) |
| common monetary policy (E52) | national output correlation (E23) |
| exchange rate passthrough (F31) | monetary policy rules (E52) |
| monetary policy rules (E52) | exchange rate passthrough (F31) |
| pricing strategies (D49) | monetary union validation (F36) |
| common monetary policy (E52) | national outputs correlation (E23) |
| floating exchange rates (F31) | welfare outcomes (I38) |
| currency area (F36) | optimal policy regime (E61) |