Currency Union
Modelling integration

The trade-off between European integration and national sovereignty lies at the core of the debate on the establishment of a single European currency. This requires the deferral of all monetary policy decisions to an international central bank, and much of the debate has focused on the extent to which national independence may be maintained through fiscal policy, while less attention has been given to the institutional features of this international monetary agency.
Each of the member countries of a currency union can increase its own purchasing power by printing more fiat money than its neighbours, so coordination is needed to prevent inflationary beggar-thy-neighbour policies. Whether or not the central bank is independent of national governments, it will need to define the monetary policy of the union, weighing the demands of the different countries.
In Discussion Paper No. 395, Research Fellow Alessandra Casella argues that in principle the international central bank of a currency union can target different money injections to different countries. This amounts to a redistribution of seigniorage revenues, and the exact outcome of the policy will depend on the influence that each country exercises on the common decision making. Casella maintains that the minimum degree of influence that each country will require if it is to remain in the union will be determined by its potential gain from abandoning it. Further, the existence of a common currency does not of itself prevent monetary policy from meeting differing national needs. In a currency union, the exchange rate is fixed by convention, but this imposes no constraints on the money supplies in different parts of the union.
Casella models these issues in a public finance framework, in which consumers' utility is a function of their consumption of a private and a public good. Different varieties of the private good are supplied by domestic and foreign firms, while the public good is provided by the domestic government and financed with lump-sum taxes and monetary issues. Governments choose both the supply and the means of financing the public good to maximize their citizens' utility, while countries differ in their endowments and thus in their desired supplies of the public good.
Without coordination, each country will ignore the effect on foreigners of withdrawing resources from private production and will therefore provide too much of the public good. Small countries will in general demand, and obtain, more than proportional power in the union, which is equivalent to a transfer of seigniorage revenues in their favour. It will therefore be impossible to sustain coordination with fixed exchange rates.
For an agreement covering several countries, all of them are small with respect to the total, and all of them will increase their relative demands for control and their propensities to deviate from the agreed monetary policy of the union. Sustaining the currency union therefore becomes increasingly difficult as the number of countries rises.

Participation in a Currency Union
Alessandra Casella

Discussion Paper No. 395, March 1990 (IM)