Working Paper: CEPR ID: DP4122
Authors: William Fuchs; Francesco Lippi
Abstract: A monetary union is modelled as a technology that makes surprise devaluations impossible but requires voluntarily participating countries to follow the same monetary policy. It is shown that for low discount factors and sufficiently correlated shocks welfare in the union is higher than that achievable when countries coordinate while retaining their own independent policy. Optimal policy, when participation in the union is voluntary, is characterized and shown to respond to agents? incentives to leave by tilting current and future policy in their favour. This contrasts with the static nature of optimal policy when participation is exogenously assumed. This finding implies that policy in the union will not be exclusively guided by area-wide developments but will occasionally take account of member countries? national developments. Finally, we show that there might exist states of the world in which the union breaks apart, as occurred in several historical episodes. The Paper thus provides a first formal analysis of the forces behind the formation, sustainability and disruption of a monetary union.
Keywords: Cross-country spillovers; Limited commitment; Monetary union
JEL Codes: C70; E50; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low discount factors + sufficiently correlated shocks (D15) | welfare in the MU (I39) |
| optimal policy in the MU (C61) | responds to incentives to leave (J63) |
| large asymmetric shocks (F41) | MU may break apart (Y40) |
| symmetric shocks (E32) | better equilibrium path in MU (C62) |