The Optimal Currency Basket under Vertical Trade Juanyi Xu ∗ Hong Kong University of Science and Technology, Kowloon, Hong Kong May 2011 Abstract This paper explores the theory of optimal currency basket in a small open economy general equilibrium model with sticky prices. In contrast to existing literature, we focus on an economy with vertical trade, where the currencies in the basket may play different roles in invoicing trade flow. In a simple two-currency basket, one currency is used to invoice imported intermediate goods and is called \import currency", while the other currency is used to invoice exported finished goods and is called \export currency". We find that the optimal weights of the import currency and the export currency depends critically on the structure of vertical trade. Moreover, if a country decides to choose a single-currency peg, the choice of pegging currency also depends on how other competing economies respond to external exchange rate fluctuations. JEL classification: F3, F4 Keywords: Vertical trade, Import currency, Export currency, Currency basket peg, Welfare ∗ Department of Economics, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. Email:
[email protected]. Tel: +852 23587604; fax: +852 23582084. 1 Introduction The purpose of this study was to re-examine the theory of the optimal currency basket for small open economies in a vertical trade context. The literature on optimal currency baskets proliferated in the early 1980s. For example, see Behandari (1985), Flanders and Helpman (1979), Flanders and Tishler (1981), and Turnovsky (1982). The optimality of a currency basket in those studies was defined mainly in terms of trade balance stabilization or real income stabilization.