Currency Unions

This 2002 Quarterly Journal of Economics paper by Alberto Alesina and Robert Barro builds a formal model of which countries should give up their own currency and adopt another country’s, combining a real trade/country-size model with a Barro-Gordon (1983) rules-versus-discretion monetary model. In the real side, competitive final-goods producers combine differentiated, monopolistically-supplied intermediate goods subject to an iceberg trading cost between countries; a reduction in this cost, including via a shared currency, raises consumption in both trading partners, and does so more for a country that trades a lot with its partner and for a country that is small relative to the world number of varieties. On the monetary side, a country that cannot itself commit to low inflation faces a discretionary inflation bias (the Barro-Gordon outcome); linking to an anchor country that can commit avoids this bias but costs the client both the ability to react to its own idiosyncratic output shocks and exposure to relative-price shocks between the two countries’ consumption baskets. Combining the two channels, the paper shows that a country gains more from adopting an anchor’s currency the harder it would find it to commit to low inflation on its own, the more it trades with and the more its business cycle is correlated with a large, low-inflation anchor, and the smaller it is. The paper also shows that a smaller anchor is less able to sustain a monetary-policy commitment against ex post pressure from a large client (the “Russia-Estonia” problem), and works out how an anchor’s optimal policy changes if clients compensate it for partially accommodating their disturbances. Finally, aggregating these individual decisions across many countries arranged by distance/trade intensity, the model predicts that currency unions form among adjacent, closely-linked countries, and that as the number of independent countries in the world rises, the equilibrium number of currencies in circulation can rise less than proportionally, or even fall.

R. J. Barro | Macro Paper Warehouse

Currency Unions