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The Political Economy of Currency Unions

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  • Kai Arvai

Abstract

How can a currency union be sustained when member states have an exit option? This paper derives how fiscal and monetary policies can ensure the survival of a common currency, i countries want to leave the union. A union-wide central bank can prevent a break-up by setting interest rates in favor of the country that wants to exit. I show how a central bank does this by following a monetary rule with state-dependent country weights. The paper then demonstrates in a simulation that a central bank can only sustain the union for a while with this rule, but not permanently and that the best way to sustain the union is through fiscal transfers.

Suggested Citation

  • Kai Arvai, 2021. "The Political Economy of Currency Unions," Working papers 850, Banque de France.
    • Handle: RePEc:bfr:banfra:850
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    1. Kobielarz, M.L., 2023. "Bailout dynamics in a monetary union," Journal of International Economics, Elsevier, vol. 142(C).

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    More about this item

    Keywords

    Currency union; Monetary policy; Lack of commitment; Exit option; Fiscal Policy;
    All these keywords.

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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