Currency areas and voluntary transfers

Abstract

Fiscal integration is recognized as an important issue in determining whether countries establish a common currency area. Fiscal integration between sovereign states is, however, limited by the ability of countries to commit to fiscal transfers. This paper supposes that fiscal transfers between countries must be voluntary and asks how this influences the choice between a currency area and a flexible exchange rate regime. It presents a model with wage rigidity in which, absent transfers, the flexible exchange rate regime is preferred. If there are transfers that equalize consumption, then the choice of exchange rate regime is irrelevant. Nevertheless, the currency area may be preferable if transfers are made voluntarily, because the currency area can sustain greater risk sharing. It is shown that the currency area can be optimal for a plausible set of parameter values. We consider the robustness of the conclusions to some modifications of the model.