Self-validating Optimum Currency Areas

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 degree of exchange rate pass-through onto export prices accounting for expected monetary policies, 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 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 preset prices in consumer 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. JEL classification: E5, F4