A Theory of International Currency: Competition and Discipline∗

We explicitly consider strategic interaction between governments to study currency com-petition and its effects on the circulation of currencies and welfare in a two-country two-currency search theoretic model. Each government finances public goods by means of seigniorage. Compared with a regime with two local currencies, a regime with one inter-national currency allows the issuer of the international currency to reduce the inflation tax while collecting more seigniorage, and forces the other issuer to raise the rate to compensate for a diminished tax base. However, the country with a local currency is sometimes con-strained by an inflation discipline: the more open a country is, the stronger is the discipline. Strategic selection of equilibrium gives rise to a further inflation discipline: the larger coun-try tries to have its currency circulate abroad, while the smaller country tries to prevent the circulation of foreign currency