@techreport{NBERw8783,
 title = "Self-Validating Optimum Currency Areas",
 author = "Giancarlo Corsetti and Paolo Pesenti",
 institution = "National Bureau of Economic Research",
 type = "Working Paper",
 series = "Working Paper Series",
 number = "8783",
 year = "2002",
 month = "February",
 URL = "http://www.nber.org/papers/w8783",
 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.},
}