The political economy of currency unions

Abstract

How can monetary and fiscal policy sustain a currency union when member states have an exit option? This paper derives an interest rate rule that features state-dependent country weights with which the central bank can prevent a break-up. A simulation reveals that this policy rule lacks firepower and can only extend the lifetime of the union for a while. While monetary policy is more potent in unions with more member states or setups with local currency pricing, it is still true that even a simple fiscal union with lump-sum transfers is better suited to prevent a break-up. Environments with lower risk sharing, the ZLB or wage rigidity make monetary policy even less effective.