DP395 | Participation in a Currency Union

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01/03/1990

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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 common currency, which 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 seigniorage revenues in its favour. With national currencies such transfer would not occur, and 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 probability of deviation rises sharply with the number of countries and of possible coalitions.