Self-validating optimum currency areas

Description

"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. In our model, firms choose the optimal degree of exchange rate pass-through to export prices while accounting for expected monetary policies, and monetary authorities choose optimal policy rules while taking firms' pass-through as given. We show that there exist two equilibria, each of which defines a self-validating currency regime. In the first, firms preset prices in domestic currency and let prices in foreign currency 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 preset prices in consumer currency, and a monetary union is the optimal policy choice for all countries. Although a common currency helps synchronize business cycles across countries, flexible exchange rates deliver a superior welfare outcome"--Federal Reserve Bank of New York web site.

Subjects

Series Statement

• NBER working paper series -- no. 8783
• Working paper series (National Bureau of Economic Research) -- working paper no. 8783.

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Other Editions

• Self-validating optimum currency areasNational Bureau of Economic Research2002-01-01
• Self-validating optimum currency areasElectronic resourceFederal Reserve Bank of New York2002-01-01