Does leaving the Eurozone mean leaving the Euro?

Fiscal concerns in the Eurozone have raised the possibility that a Eurozone member departs the currency union. We devise a simulation to examine whether trading firms in the departed country will continue to invoice their product in the Euro or elect another currency denomination strategy.  Because trading firms have great flexibility in choosing a currency to conduct business, they make an excellent case for studying the currency usage patterns of other economic actors that may emerge after Eurozone departure. 

We make use of a partial equilibrium simulation calibrated to real data similar to Floden and Wilander (2006), Gopinath and Itskhoki (2010) and Witte (2009).  We simulate 5,000 representative firms by randomly assigning random variables associated with the firm’s characteristics, the industry’s characteristics and macroeconomic characteristics such as exchange rate volatility. 

Our results suggest that the optimal level of price discrimination plays a dominant role in the observed currency denomination of trade.  When there is greater price discrimination, a representative firm is much more likely to use local currency pricing (LCP).  However, if the representative firm wishes to set the same in price in all markets then the U.S. Dollar is the overwhelming choice. Results suggest that the representative firms will prefer to set only one price in all markets when the exiting country’s newly created currency has low exchange rate volatility with the U.S. Dollar but high exchange rate volatility with the Euro.         

Another important factor for the currency denomination in all markets is the variance of the relevant exchange rates.  In the exiting country the Euro is more likely to be used when the exchange rate variance between the Euro and exiting country’s currency is low and exchange rate variance between the U.S. Dollar and the exiting country’s currency is high.  Likewise, in the remaining Eurozone, there’s more Euro currency invoicing when there is low exchange rate variance between the Euro and the exiting country’s currency.  Lastly, in the non-Euro country there’s more LCP when the exchange rate variance between the exiting country’s currency and the non-Euro country’s currency is low.