A Theory of International Currency and Seigniorage Competition
This paper explicitly considers strategic interaction between governments to study currency competition and its effects on the circulation of currencies and welfare in a two-country, two-currency search theoretic model. Each government uses seigniorage to provide public goods. Agents consume private goods, and the public goods of their own country. We have several findings. The negative impact of a country's inflationary policy on the realm of circulation of its currency imposes an inflation discipline: the more open a country is, the stronger is the discipline. The worldwide circulation of a currency increases seigniorage and welfare and decreases the inflation rate of the issuing country compared to autarky. The other country, since the tax base is reduced due to the use of foreign currency, raises its inflation rate. However, there is a limit on the rate beyond which it cannot maintain the circulation of national money. Under strategic interaction between governments in selecting equilibrium, the larger country would try to lower the inflation rate to make its currency circulate abroad, while the other country may also lower the inflation rate to sustain its national currency as the sole medium of exchange.
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