Working Paper: CEPR ID: DP3484
Authors: Laura Bottazzi; Paolo Manasse
Abstract: In a Common Currency Area (CCA) the Common Central Bank sets a uniform rate of inflation across countries, taking into account the area?s economic conditions. Supposing that countries in recession favor a more expansionary policy than countries in expansion, a conflict of interest between members arises when national business cycles are not fully synchronized. If governments of member countries have an informational advantage over the state of their domestic economy, such conflict may create an adverse selection problem: national authorities overemphasize their shocks, in order to shape the common policy towards their needs. This creates an inefficiency over and above the one-policy-fits-all cost discussed in the optimal currency area literature. In order to minimize this extra-burden of asymmetric information, monetary policy must over-react to large symmetric shocks and under-react to small asymmetric ones. The result is sub-optimal volatility of inflation.
Keywords: asymmetric information; common currency areas; monetary policy
JEL Codes: E00; E50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Informational advantages of national governments (H10) | Misrepresentation of economic conditions (E66) |
| Misrepresentation of economic conditions (E66) | Influence on monetary policy (E52) |
| Influence on monetary policy (E52) | Adverse selection problems (D82) |
| Adverse selection problems (D82) | Inappropriate monetary policies (E49) |
| Inappropriate monetary policies (E49) | Inflation variability (E31) |
| Asymmetric information (D82) | Suboptimal volatility of inflation (E31) |
| Asymmetric information (D82) | Welfare losses (D69) |
| Large symmetric shocks (E32) | Overreaction by common central bank (E58) |
| Small asymmetric shocks (E32) | Underreaction by common central bank (E58) |
| Disregarding magnitude of reported shocks (C22) | Increased inflation variability (E31) |