A Monetary Union is modelled as a technology that makes a surprise policy deviation impossible but requires voluntarily participating countries to follow the same monetary policy. Within a fully dynamic context, we identify conditions under which such arrangement may dominate a coordinated system with independent national currencies. Two new results are delivered by the voluntary participation assumption. First, optimal policy is shown to respond to the agents’ incentives to leave the union by tilting both current and future policy in their favor. This contrasts with the static nature of optimal policy when participation is exogenously assumed and implies that policy in the union is not exclusively guided by area-wide developments but does occasionally take account of member countries’ national developments. Second we show that there might exist states of the world in which the union breaks apart, as occurred in some historical episodes. The paper thus provides a first formal analysis of the incentives behind the formation, sustainability and disruption of a Monetary Union.
Published in 2006 in: Review of Economic Studies, v. 73, pp. 437-457
