Optimal Payment Areas or Optimal Currency Areas?

Abstract

We use the Optimal Capital Structure of Nations framework in Bolton and Huang (2018) to develop a new theory of Optimum Currency Areas. Whether two economically integrated nations should form an optimal currency area depends on a trade-off between financial flexibility (the value of monetary sovereignty) and monetary discipline (the commitment not to engage in competitive monetizations). We show that a monetary union works best when combined with a fiscal union and fiscal transfers. We also show that debt monetization is still desirable in a monetary union when both member-countries simultaneously face a negative output shock.