Money, Sovereignty, and Optimal Currency Areas

57 Pages Posted: 18 Aug 2018

See all articles by Patrick Bolton

Patrick Bolton

Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Haizhou Huang

China International Capital Corporation Limited

Date Written: August 4, 2018

Abstract

We propose a new theory of Optimum Currency Areas (OCAs) based on monetary sovereignty. We consider two economically integrated countries with separate currencies and monetary policies, but with exchange rate underreaction. We show that the two countries are then engaged in a strategic monetization game, which may generate excessive inflation in equilibrium. A monetary union between the two countries can eliminate this excess inflation cost, but also removes a nation's monetary sovereignty. By eliminating the option to monetize debt in times of exigency, a monetary union may give rise to costly debt defaults. Joining a monetary union therefore involves trading excess monetization costs for debt default costs. Allowing for fiscal transfers within the union and for the option of debt monetization in a generalized crisis are optimal features of a monetary union. Our model also provides a coherent analytical framework that helps shed light of the recent history of OCAs.

Keywords: Money, Currency Union, Monetary Sovereignty, Strategic Monetization

JEL Classification: E42, E58, F45, F55

Suggested Citation

Bolton, Patrick and Huang, Haizhou, Money, Sovereignty, and Optimal Currency Areas (August 4, 2018). Columbia Business School Research Paper No. 18-66. Available at SSRN: https://ssrn.com/abstract=3226185 or http://dx.doi.org/10.2139/ssrn.3226185

Patrick Bolton (Contact Author)

Columbia Business School - Department of Economics ( email )

420 West 118th Street
New York, NY 10027
United States

HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Haizhou Huang

China International Capital Corporation Limited ( email )

28th Floor, China World Tower 2
No. 1 Jian Guo Men Wai Avenue
Beijing 100004
United States

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