Self-Validating Optimum Currency Areas

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.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.

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