Abstract

This paper investigates the effects of members’ exits from a currency union on the credibility of the common currency. In our currency union model, the inflation rate of the common currency is determined by majority voting among N member countries that are heterogeneous with respect to their output shocks. Once an inflation rate of the common currency has been selected, each member decides whether to remain in the currency union or not. If a member decides to exit, it has to pay a fixed social cost and individually chooses the inflation rate of its currency. Unlike previous research on this topic, we focus on the possibility of achieving an optimal outcome, which generates no inflation bias, when more than one member is expected to leave the currency union. We show that the optimal outcome can only be achieved if no members leave the currency union.

Highlights

  • This paper examines the effects of members’ endogenous exit decisions from a currency union on the possibility of implementing an optimal monetary policy

  • The possibility of exit leads the public to expect discretionary policymaking in the future, which influences the expectations about the inflation rate, as well as the optimal institutional design of the currency union

  • Given the above discussion as motivation, this paper examines the effects of members’ exits from a currency union on the possibility of achieving zero inflation bias in equilibrium

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Summary

Introduction

This paper examines the effects of members’ endogenous exit decisions from a currency union on the possibility of implementing an optimal monetary policy. Uribe [11] studied exit decisions from a currency union with a focus on sovereign debt defaults Compared with these studies, our work endogenizes the exit decisions of member countries that lack credibility and shows that the optimal outcome cannot be achieved in an environment where some members leave the currency union. Barro and Gordon [1] showed that the time inconsistency problem induces inflation bias in monetary policymaking and highlighted the benefit of commitment rules rather than discretionary policymaking. Since those studies, a considerable amount of research has investigated ways to relax the inflation bias ([13,14,15,16,17,18]).

Setting
Exits and Inflation Bias
Conclusions

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