Exit Expectations, Time Inconsistency, and the Optimal Design of a Currency Union

In a currency union, monetary policies are determined collectively by the member countries. For countries’ lacking commitment, one benefit of belonging to a currency union is that a country’s monetary policy gains credibility by loosing their monetary autonomy. Focusing on this benefit of belonging to a currency union, this paper analyses the effect of an exogenous rise in the expectation of members’ exit on the currency union’s optimal design. Our two main results are as follows. First, higher expectations of a country’s exit enable the public to anticipate a higher probability of domestic discretionary policymaking in the future. Since the public knows that the authority has an incentive to generate surprise inflation, we have a higher expected inflation rate accompanied by a lower growth rate at the rational expectation equilibrium. Second, a higher exit expectations of advanced countries increases the optimal share of developing countries in the currency union from the advanced countries’ perspective. In other words, unlike the traditional theory of optimal currency areas, a higher exit probability requires a greater portion of member countries with dissimilar economic backgrounds to be in the currency area. (JEL: E5; E4)