Monetary unions and international monetary policy coordination agreements are both fragile and dangerous. They are dangerous since they affect the way in which economies react to worldwide events. They are also fragile since their constitutions must lay down a well-thought out set of principles and rules in order to achieve their desired objectives, to induce the optimal degree of participation, and to ensure the loyalty of their members. In Discussion Paper No. 1180, Antonio Morales and Research Affiliate Jorge Padilla provide some formal guidance for the design of such principles and rules, which are at the heart of any monetary union or coordination agreement. To do this, they study a world economy consisting of closely interrelated economies, which undertakes adjustment to an unfavourable common supply shock. In this economy, each country's output and inflation levels depend positively on domestic and foreign monetary policies, which in the absence of any international coordination agreement, are conducted solely and non-cooperatively according to the output-inflation preferences of democratically elected domestic governments.

The authors show that since domestic monetary policies have spillover effects on foreign countries, worldwide monetary policy coordination is essential to achieve an optimal adjustment to the common shock, that is, to avoid the deflationary (inflationary) bias that arises in the absence of coordination when the monetary spillovers are positive (negative). Its actual implementation requires careful design to ensure that each country finds it optimal to join and to remain faithful to the coordination agreement. The authors construct alternative coordination mechanisms which implement the first-best response to the common shock, discuss their main properties and rank them according to different criteria of desirability.

Designing Institutions for International Monetary Policy Coordination
Antonio J Morales and A Jorge Padilla

Discussion Paper No. 1180, May 1995(IM)