Coalition Formation in International Monetary Policy Games
Bank of England Working Paper No. 92
67 Pages Posted: 6 May 1999
Date Written: February 1999
It is well known from the analysis of monetary policy coordination of two countries that coordination often Pareto-dominates the outcome of the non-cooperative game. Hence both countries will have an incentive to form a union when it is certain that the other country will also join.
However, in an n-country model, free-riding incentives restrict the size of a stable coalition to less then n countries. Since the coalition members are bound by the union's discipline, an outsider can successfully export inflation without fearing that the insiders will try to do the same.
The formation of a large currency bloc is not sustainable since it would impose too much discipline on all participants. However, the co-existence of several smaller currency blocs may be a second-best solution to the free-riding problem of monetary policy coordination.
JEL Classification: E52, E58, E61
Suggested Citation: Suggested Citation