Participation in a Currency Union

Abstract

When countries of different sizes participate in a cooperative agreement, the potential gain from deviation determines the minimum power that each country requires in the common decision-making. This paper studies the problem in the context of a monetary union - multiple countries sharing a common currency - whose very existence requires coordination of monetary policies. In the presence of externalities in the decentralized equilibrium with national currencies, it is shown that a small economy will in general require, and obtain, more than proportional power in the agreement. With a common currency, this is equivalent to a transfer of seignorage revenues in its favor. With national currencies such transfer would not obtain, and the small country would be even more demanding. Without additional unconstrained fiscal instruments it would be impossible to sustain coordination with fixed exchange rates. When the number of potential countries in the union is large, it is not generally possible to prevent deviations from individual countries or from coalitions. The currency union might emerge as a mixed strategy equilibrium, but the probability of deviation rises sharply with the number of countries and of possible coalitions.