Monetary Union with Voluntary Participation Fuchs and Lippi by Lovleen Kushwah April 2013
Motivation Non-cooperative decisions by the policy-makers of different countries produce inefficient outcomes. European monetary union (17), Gulf Cooperation Council (6), South-east Asia (9), African countries, Belgium-Luxembourg MU. A rationale for monetary unions: Second best institution design arises when first-best coordination of policy is not feasible. Coordination vs. flexibility. Why a second-best arrangement, in which countries deliberately give up policy independence, may dominate other forms of coordination, which do not involve a loss of flexibility?
Monetary Union A MU is a technology that makes a surprise policy deviation impossible and requires voluntarily participating countries to follow the same monetary policy. Deviation from the coordinated policy delivers a smaller pay-off when it is anticipated than when it comes as a surprise to other agent.
Contribution Welfare achievable under the repetition of the static Nash equilibrium (sort of a benchmark). Underlying strategic environment is dynamic. MU dominates a regime with independent national currencies (INMP). Enforced participation. Volutary joint policy-making may make the union sustainable. Policy responds to the agents incentives to leave the union by tilting both current and future policy in their favour. Time-invariant Pareto weights /Local conditions. Break-ups may be efficient
Monetary Union Revisited Cost of MU: Use of same policy when hit by asymmetric shocks may be inefficient. Benefit of MU: Unilateral surprise deviations impossible. Depending on the distribution of the shocks and discount factors, MU might be permanent or temporary. A break-up occurs if for a large asymmetric shock the costs of following a common policy outweight the future benefits of the MU.
Environment Two infinitely lived ex ante identical countries: Home and Foreign (*) Poicy instrument: π,π State space s is discrete and i.i.d rv with a support S and probabilties p s. Pay-off irrelevant r.v. x t U[0, 1], a public randomization device Per period utility U(π, π, s),u (π, π, s), is bounded, jointly differeniable. Inter-temporal utility: E 0 t=0 δt U(.) h t = h(π t 1 s,π t 1 and s t s,x t s) is the history at time t
Independent National Monetary Policy (INMP) regime Timing s t and the x t are observed, Countries simultaneously set policy π(ht ), π (h t ). Set of subgame-perfect policy pairs Γ. Set of subgame-perfect pay-offs, W.
Monetary Union (MU) regime Common Policy: π = π Timing: st and the x t are observed, (as under INMP) Announce a(ht ), a (h t ) simultaneously. Follow common policy (a = 0) or not (a = 1). If a = a = 0, the common policy is implemented and the union is continued into the future. Otherwise, the union is dissolved and countries revert to playing some subgame-perfect equilibrium of the INMP game MU contract consists of three history-dependent rules Dissolution rule, D Common Policy rule, Π INMP game equilibrium, β if union dissolves
Monetary Union (MU) regime Efficient frontier
Monetary Union (MU) regime Sustainability of the MU Post-break-up equilibria Set of INMP payoffs, W, and MU-sustainable pay-offs, V.
An Example Time-varying policy targets : ɛ t and ɛ t State s = (ɛ t, ɛ t ) i.i.d. with same mean and variance. Non zero covariance. Inter-temporal objective function: V = t=0 δt U t Per period utility INMP With reputation,fb is sustainable if either δ punishment is more severe than Nash α2 α 2 2w or
An Example In MU, participation constraint should be additionaly satisfied. Policy is a convex combination of the preferred policies by Home (ɛ t ) and Foreign (ɛ t ): π s = κ s ɛ t + (1 κ s )ɛ t, where κ s depends on which PC binds.
An Example : Numerical results δ = 0.1; s = (ɛ t, ɛ t ) = {(1, 0), (0, 1), (2, 0), (0, 2)}; p s = {0.3, 0.3, 0.2, 0.2} MU with break-ups: α = 2, s = {(1, 0), (0, 1), (3, 0), (0, 3)}
Conclusions Paper explors the motives behind a country s choice to voluntarily adopt such a constraint, as it occurs in an MU. Novelties: Formation, sustainability, and disruption of a MU under voluntary participation, workings of supra-national institutions (ECB) Extensions: Fiscal policies in an MU, more persistent shocks, more than two countries and one sided lack of commitment (dollarization).