When countries of different sizes participate in a cooperative agreement, the
potential gain from deviation determines the minimum power that each country requires
in the common decision-making.
This paper studies the problem in the context of a monetary union - multiple
countries sharing a common currency - whose very existence requires coordination
of monetary policies. In the presence of externalities in the decentralized equilibrium
with national currencies, it is shown that a small economy will in general
require, and obtain, more than proportional power in the agreement. With a common
currency, this is equivalent to a transfer of seignorage revenues in its favor.
With national currencies such transfer would not obtain, and the small country
would be even more demanding. Without additional unconstrained fiscal instruments
it would be impossible to sustain coordination with fixed exchange rates. When
the number of potential countries in the union is large, it is not generally possible
to prevent deviations from individual countries or from coalitions. The
currency union might emerge as a mixed strategy equilibrium, but the probability
of deviation rises sharply with the number of countries and of possible coalitions.
*Published:
American Economic Review, Sept 1992
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