Endogeneity of the Optimal Currency Area Revisited

By fixing the exchange rate, a country rules out the possibility of using the exchange rate to adjust to aggregate demand shocks. But adjustment may be enhanced if internal prices are more flexible. This paper asks whether this increase in price flexibility is likely to take place endogenously after an an exchange rate peg. We find that the answer is yes in the case of an unilateral peg followed by one country alone. On the other hand, when an exchange rate peg is supported by bilateral participation of both monetary authorities, the degree of price flexibility may actually be less than under freely floating exchange rates. Finally, our model allows for multiple, self-fulfilling equilibria in the degree of price flexibility. In that case, a peg may cause a dramatic increase in the flexibility of prices.