TY  - JOUR
AU  - Corsetti,Giancarlo
AU  - Pesenti,Paolo
TI  - Self-Validating Optimum Currency Areas
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 8783
PY  - 2002
Y2  - February 2002
UR  - http://www.nber.org/papers/w8783
L1  - http://www.nber.org/papers/w8783.pdf
N1  - Author contact info:
Giancarlo Corsetti
Faculty of Economics
Cambridge University
Sidgwick Avenue
CB3 9DD Cambridge, Cambs
United Kingdom
Tel: +44(0)1223335235
E-Mail: giancarlo.corsetti@gmail.com

Paolo A. Pesenti
Federal Reserve Bank of New York
33 Liberty Street
New York, NY 10045
Tel: 212/720-5493
Fax: 212/720-6831
E-Mail: paolo.pesenti@ny.frb.org
AB  - 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.
ER  -