Working Paper: CEPR ID: DP13987
Authors: Enrico Perotti; Oscar Soons
Abstract: We analyze the political economy of monetary unification among countries with different quality of institutions. Countries with stronger institutions have lower public spending and better investment incentives, even under a stronger currency. Governments under weaker institutions spend more so must occasionally devalue. In a MU market prices and flows adjust quickly but institutional differences persist, so a diverse monetary union (DMU) has many redistributive effects. The government in the weaker country expand spending and investment may be reduced by the fiscal and common exchange rate effect. Strong country production benefits from the weaker currency but needs to offer fiscal support in a fiscal crisis, a transfer legitimized by its ex ante devaluation gain. Some governments may join a DMU even if it depresses productive capacity to expand public spending. Even in a DMU beneficial for all countries, workers and firms in weaker countries and savers in stronger countries may lose.
Keywords: Monetary Unions; Institutions; Political Economy; Institutional Quality
JEL Codes: D02; D72; F33; F45
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stronger institutional quality (O17) | lower public spending (H59) |
| stronger institutional quality (O17) | higher investment incentives (G31) |
| weaker institutional quality (O17) | higher public spending (H59) |
| weaker institutional quality (O17) | potential devaluation (F31) |
| lower public spending (H59) | better economic performance (P17) |
| higher investment incentives (G31) | better economic performance (P17) |