Welfare Implications of Currency Integration: Labor Mobility and Pricing-to-Market

Abstract

In this paper, we examine the welfare cost of renouncing monetary policy autonomy in a model that includes labor mobility and pricing-to-market (PTM) behavior in firms. We find that renouncing monetary policy autonomy becomes a cost of currency integration when the consumption basket weights differ between candidate countries and when country-specific total factor productivity (TFP) shocks hit economies, even when the union fulfills the classic optimum currency area theory of labor mobility. We also found that a firm's PTM behavior has a significant effect on the welfare implications of currency integration combined with labor mobility. For instance, currency integration does not produce greater welfare losses in the PTM case (where the labor input weights differ across member countries and asymmetric labor disutility shocks occur), although greater welfare losses arise in the case of producer currency pricing.

Key Words:

• Open economy model
• currency integration
• labor mobility
• exchange rate regime
• pricing-to-market

Jel Classification:

• E52
• F33
• F36
• F41

Acknowledgements

I have benefited from discussions with and the comments of Shin-ichi Fukuda, Eiji Ogawa, and Tsutomu Watanabe. I also would like to thank the seminar participants at Hitotsubashi University, Nanzan University and the Research Institute of Capital Formation, the Development Bank of Japan. All remaining errors are mine.

Notes

1. Khalaf and Kichian (2004), Mallick and Marques (2012) and Byrne et al. (2013) pointed out the existence of PTM too.

2. See De Grauwe (2012) for the review of the OCA literature.

3. Following Mundell's (1961) labor mobility, authors have added many criteria for optimum currency areas. See McKinnon (1963) and Kollmann (2004) for the openness of the economy, Kenen (1969) for fiscal coordination and symmetry of economic structures, Corden (1972) and Giersch (1973) for similarity of countries’ preferences for inflation and unemployment, Bruno and Sachs (1985) and Calmfors and Driffill (1988) for the similarity of member countries’ labor markets, Dornbusch et al. (1998), Cecchetti (1999), Maclennan et al. (1999), Mojon (2000) and Peersman and Smets (2001) for the similarity in legal systems.

Additional information

Funding

This work was supported by the Japan Society for the Promotion of Science (JSPS), Grant-in-Aid for Young Scientists (A) [15H05393].