Endogenous Currency of Price Setting in a Dynamic Open Economy Model

Abstract

Many papers in the recent literature in open economy macroeconomics make different assumptions about the currency in which firms set their export prices when nominal prices must be pre-set. But to date, all of these studies take the currency of price setting as exogenous. This paper sets up a simple two-country general equilibrium model in which exporting firms can choose the currency in which they set prices for sales to foreign markets. We make two alternative assumptions about the structure of international financial markets: one where there are complete markets for hedging consumption risk internationally, and the other without risk-sharing possibilities. Our results are quite sharp: exporters will generally wish to set prices in the currency of the country that has the most stable monetary policy. When monetary stability is similar among countries, there is an equilibrium where firms from all countries set their price in the currency of the buyer (local currency pricing). But except for a special case where money variances are exactly identical across countries, there is no equilibrium where all firms set export prices in their own currencies (producer currency pricing).