Monetary Unions
Creating a constitution

Monetary unions require constitutions to govern the distribution of authority to take account of both union-wide and regional or national interests, and a balance is often achieved by the appointment to the central bank council of representatives of the individual regions as well as those taking a more global view. In Discussion Paper No. 919, Research Fellow Jürgen von Hagen and Ralph Süppel investigate which of the available alternative institutional arrangements will be preferred by a `representative' household. They develop a standard monetary policy model in which a central bank council that reaches decisions by simple majority seeks to stabilize employment around target rates above the natural rate, which introduces an inflation bias. For simplicity, `governors' (appointed by the central administration or jointly by all members) and `state representatives' care only about the union or their own states.

Von Hagen and Süppel find that long-run inflation performance depends critically on the union's political structure. If the centre exercises little political power, it fares best with a council of governors, but with substantial power at the centre the union fares better with a council dominated by state representatives. In this case, the conflict between efficient stabilization and long-run price stability may be resolved by allowing state representatives to determine long-run monetary policy while the governors conduct short-run stabilization policy between council meetings and are accountable to the state representatives.

Von Hagen and Süppel conclude that the Maastricht Treaty was misguided for two reasons. First, the optimal design of the council depends on member states' preferences and the stochastic structure of shocks hitting individual regions, so the constitution of the central bank should not have been written before the union's members were identified. Second, preferences and stochastic structures are unlikely to remain fixed indefinitely, so a constitution should make provision for its amendment; national parliaments may enact this more easily if it takes the form of a simple law rather than forming part of an international treaty.

Central Bank Constitutions for Monetary Unions
Jürgen von Hagen and Ralph Süppel

Discussion Paper No. 919, March 1994 (IM)