DP3436 Common Currencies versus Monetary Independence

Author(s): Thomas F Cooley , Vincenzo Quadrini

Publication Date: June 2002

Keyword(s): optimal monetary policy , international coordination , common currency

JEL(s): E00 , E50 , F00

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3436.asp

We study the optimal monetary policy in a two-country open-economy model under two monetary arrangements: (a) multiple currencies controlled by independent policy-makers; (b) common currencies controlled by a centralized policy-maker. Our findings suggest that: (i) Monetary policy competition leads to higher long-term inflation and interest rates with large welfare losses; (ii) The inflation bias and the consequent losses are larger when countries are unable to commit to future policies; (iii) in both cases, the welfare losses from higher in ation dominates the welfare costs of losing the ability to react optimally to business cycle shocks. Therefore, the coordination of policies implicit in the adoption of a common currency or dollarization has positive welfare consequences.