Working Paper: NBER ID: w2740
Authors: Alessandra Casella; Jonathan Feinstein
Abstract: This paper presents a simple general equilibrium model of two countries using a common currency. The goal is to study how the monetary arrangement influences the optimum financing of a public good. If the two countries are allowed to print the common currency autonomously, they will finance their fiscal spending with money, oversupplying the public good and crowding out the private sector. The possibility to export part of the inflation creates a distortion in incentives such the resulting equilibrium is strictly welfare inferior to the one prevailing under flexible exchange rates. If the management of the common currency is deferred to an international central bank, each country will try to use domestic policy variables (taxes) to manipulate in its favor the actions of the bank. With no independent domestic taxes, the bank can improve welfare. However, its policies naturally support the larger country, and to induce the smaller one to participate requires giving it a disproportionately large, politically unrealistic, representation in the bank's objective function.
Keywords: common currency; monetary integration; public goods; welfare outcomes
JEL Codes: E42; E52; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| autonomous issuance of currency (E42) | oversupply of public goods (H49) |
| oversupply of public goods (H49) | crowding out of the private sector (E62) |
| crowding out of the private sector (E62) | reduced overall welfare (D69) |
| delegation of currency management to an international central bank (F33) | manipulation of tax policies by countries (H26) |
| manipulation of tax policies by countries (H26) | reduced effectiveness of the central bank (E58) |
| absence of taxes (H29) | potential improvement of welfare by the central bank (E58) |