While distortionary, inflation is desired as it taxes the money holdings of foreign agents and thus benefits home citizens.4 In contrast, a central bank under a monetary union will internalize the interdependence between countries and optimally choose a lower inflation rate.
While this argument is cast here through an abstract seignorage game between governments, there is a very general and powerful point underlying the analysis: the gains to centralization arise from the internalization of the external effects of national policies. This theme appears often in the literatures on fiscal federalism and trade policies as well.5 With reference to monetary policy, the European Commission report (Emerson et al. [1992, pg. 114]) notes, the adoption of a common monetary policy handled by EuroFed will remove the possibility of beggar-thy-neighbour monetary and exchange rate policies.”
Overall, monetary union eliminates both allocative inefficiencies and distortions from inflation. Because governments are unable to influence terms of trade through their control of the stock of local currency, agents are no longer taxed by the inflation policy of other governments. Furthermore, agents can meet their random liquidity needs out of their holdings of the single currency. Thus, as in the European Commission’s report, monetary union increases efficiency by eliminating distortionary inflation and providing a market structure which supports the ex post efficient allocation of goods.
We axe then naturally led to the second theme of this paper. Having identified gains to monetary union within our model, establishing a monetary union should be a relatively easy matter. However, we show that it is actually impossible for countries to reap the gains to monetary union without entering into a cooperative agreement for the construction of a monetary union.
To develop this theme, Section IV of the paper studies a game in which government choose both their monetary institutions (whether or not to impose local currency requirements) and their inflation rates. We first argue that the allocation under a monetary union is identical to that achieved in a world economy with local currencies as long as governments do not impose a local currency requirement and do not inflate. However, we show that, acting independently, governments will choose to deviate from the monetary union outcome by imposing local currency requirements and inflating. That is, the monetary union allocation is not a Nash equilibrium of our game.
We provide conditions such that the Nash equilibrium entails the imposition of local currency requirements and positive inflation.