Coalition formation in international monetary policy games
It is well known from the analysis of monetary policy co-ordination of two countries that co-ordination often Pareto-dominates the outcome of the non-co-operative game. Hence both countries will have an incentive to form a union when it is certain that the other country will also join. However, in an n-country model, free-riding incentives restrict the size of a stable coalition to less then n countries. Since the coalition members are bound by the union's discipline, an outsider can successfully export inflation without fearing that the insiders will try to do the same. The formation of a large currency bloc is not sustainable since it would impose too much discipline on all participants. However, the co-existence of several smaller currency blocs may be a second-best solution to the free-riding problem of monetary policy co-ordination.
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