Monetary Union with Voluntary Participation(November 2003

A Monetary Union is modeled as a technology that makes a surprise policy deviation impossible and requires voluntarily participating countries to follow the same monetary policy. Within a fully dynamic context, we show that such an arrangement may dominate a regime with independent national currencies. Two new results are delivered by the voluntary partici-pation assumption. First, optimal policy is shown to respond to a countrys temptation to leave the union by tilting both current and future policy in its favor. This yields a non-linear rule according to which each country weight in policy decisions is time-varying and depends on its incentive to abandon the union. Second, we show that there might be conditions such that a break-up of the union, as occurred in some historical episodes, is e ¢ cient. The paper thus provides a \u85rst formal analysis of the incentives behind the formation, sustainability and disruption of a Monetary Union