A note on exit and inflation bias in a currency union

This note investigates how the threat of a member’s exit from a monetary union affects the inflation bias of the common currency. The canonical Barro-Gordon model is extended to a currency union setting, where the monetary policy is determined by majority voting among the N member countries, which are heterogeneous with respect to the within- country output shocks. Once the policy is selected, each member decides whether to remain in the monetary union or not. If a country decides to exit, it has to pay a fixed social cost. If a member leaves the monetary union, it individually chooses the inflation of its own currency. It is shown that inflation bias is generated if more than one member exits. In other words, the optimal monetary policy, which does not generate inflation bias, can be implemented only if no members exit.