The traditional Mundellian criterion for optimal currency areas, which implicitly assumes commitment to monetary policy, is that countries with similar shocks should form unions. Without such commitment a new criterion emerges: countries with dissimilar temptation shocks, namely those that exacerbate time inconsistency problems, should form unions. Crucially, all countries influence policy in that policy is chosen either cooperatively or by majority rule. Our model, applied to the European Monetary Union, captures the idea that many Southern European countries gained credibility by joining the union and motivates why Northern European countries chose to admit countries with historically lower credibility.
Bibliographical noteFunding Information:
The authors thank Fernando Alvarez, Marios Angeletos, Andrew Atkeson, David Backus, Hal Cole, Harris Dellas, Mick Devereux, Emmanuel Farhi, Gita Gopinath, Francesco Lippi, Vincenzo Quadrini, Ken Rogoff, Ivan Werning, and Mark Wright, Joan Gieseke for editorial assistance, and the NSF for supporting this research. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
- Flexible exchange rates
- Optimum currency areas