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"Establishing a Monetary Union"

Russell Cooper and Hubert Kempf

IED Discussion Paper 88, August 1998

Almost a decade has now passed since the European Commission’s proposal for a monetary union in 1990. Most of the arguments put forward for the common currency system may be classified under two broad headings: efficiency and price stability. These have typically included reductions of trading frictions, larger and more integrated markets, reduction in the levels and variability of inflation, and in output fluctuations. Cooper and Kempf’s paper clarifies the economic logic underlying these arguments. Their model follows a (dynamic) general equilibrium approach rather than the one based on standard currency areas. This has the effect of allowing private agents and governments to act optimally. The authors compare equilibrium outcomes under the local currencies regime vis-a-vis monetary union. The paper identifies two key gains to monetary union, paralleling the arguments used by the European Commission. First, the adoption of a single currency reduces frictions arising from currency restrictions: namely, the entirely natural requirement that local currencies are necessary to purchase items of each country. The authors argue that adoption of a single currency facilitates agents’ responses to taste shocks, and leads to

greater allocative efficiency.

Second, their work ‘confirms’ the European Commission’s optimistic pronouncement on the effects on price stability of the union. One of the results of the paper suggests that governments - in the context of multiple currencies and local currency cash-in-advance constraints - maximize national welfare by targeting monetary policy to achieve excess inflation. The intuition for such a distortion seems to be that by inflating, governments can tax foreign holders of their currency and benefit home citizens in the process. However, the cost is reflected in lower levels of output and employment. Cooper and Kempf show that by eliminating this ‘inflation competition’, the union can increase the welfare of people in each country.

The benefits of union naturally raise the question of how the transition can be successfully implemented. Cooper and Kempf show that it may be impossible for countries to reap these gains without entering into a cooperative agreement: they study a game in which governments choose both their monetary institutions and inflation rates. They isolate conditions under which a monetary union is not a Nash equilibrium of the game. Hence, the analysis seems to confirm actual experience in Europe this decade where significant costs have had to be incurred and a treaty signed to achieve the vision of the European Monetary Union.