European Monetary Union
Trade effects

Reduced transaction costs are widely viewed as one of the principal advantages of European Monetary Union, but their influence on the composition and the size of the different markets remains a neglected issue. A common currency would imply not only lump-sum savings but also a change in the division of traders between domestic and international activities, and a distortionary common inflation rate may also affect the formation of markets. In Discussion Paper No. 595, Research Fellow Alessandra Casella sets up a model with heterogeneous agents in two countries with identical economic structures, to study the responses of market size and therefore individual and aggregate income to the change in monetary regime. One country provides a more stable currency, which is used in all international transactions; some traders belong to a purely domestic market, while the others enter the international market. Each trader is then randomly matched to partners from those who have selected the same market. The return from a transaction depends on the two partners' endowments and on an index of monetary discipline that is negatively correlated to inflation. Inflation is created by government financing of deficits through money creation; so for given government expenditure, the index of monetary stability must be increasing in taxes.
In Casella's model, traders first learn their type and decide which market to join; the governments then determine inflation and taxes. She compares the equilibria under national currencies and a single money and models the results of referenda in both countries on the choice of regime for different values of a `development parameter' that affects market size and productivity. A majority in the high-inflation country favour monetary unification at earlier stages of development, when productivity is low, and transaction costs from the use of the foreign currency in international trade are high relative to income. In the low-inflation country, the referendum approves a common currency at higher levels of development, when international markets are wide.
Casella concludes that so long as the international reserve currency constrains the independence of national monetary policies, there is general support for monetary unification only at intermediate values of the development parameter. Her model identifies one reason for Germany's support for monetary unification: the Bundesbank's concern at the rising international role of the Deutschmark and the lack of flexibility that may accompany its responsibility for the management of an international reserve currency. Casella's model also ties the choice of monetary regime explicitly to the development of markets and stresses the changing attitudes towards a common currency. It may therefore provide a means of choosing the appropriate moment for such a currency reform.

Voting on the Adoption of a Common Currency
Alessandra Casella

Discussion Paper No. 595, October 1991 (IM)