DP3436 Common Currencies versus Monetary Independence

Author(s): Thomas F Cooley, Vincenzo Quadrini
Publication Date: June 2002
Keyword(s): common currency, international coordination, optimal monetary policy
JEL(s): E00, E50, F00
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3436

We study the optimal monetary policy in a two-country open-economy model under two monetary arrangements: (a) multiple currencies controlled by independent policy-makers; (b) common currencies controlled by a centralized policy-maker. Our findings suggest that: (i) Monetary policy competition leads to higher long-term inflation and interest rates with large welfare losses; (ii) The inflation bias and the consequent losses are larger when countries are unable to commit to future policies; (iii) in both cases, the welfare losses from higher in ation dominates the welfare costs of losing the ability to react optimally to business cycle shocks. Therefore, the coordination of policies implicit in the adoption of a common currency or dollarization has positive welfare consequences.