Rethinking optimal currency areas

Abstract

The traditional Mundellian criterion, which implicitly assumes commitment to monetary policy, is that countries with similar shocks should form unions. Without such commitment a new criterion emerges: countries with dissimilar temptation shocks, namely those that exacerbate time inconsistency problems, should form unions. Critical to this new criterion is the idea that monetary policy is benevolent in that it takes into account the interests of all the countries in the union. When countries have dissimilar temptation shocks, benevolent unions can help overcome the time inconsistency problems that individual countries face. Existing unions can strictly gain by admitting new members with more severe time inconsistency problems, because policy in the expanded union is less sensitive to the temptation shocks of members of the existing union.