Rethinking Optimal Currency Areas

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.