MONETARY UNION: World Economy with Local Currencies

In this way, the paper also contributes to the theoretical international macroeconomics literature by providing ал explanation for local currency cash-in-advance constraints.
In fact, the game between governments is one of a prisoners dilemma with the monetary union outcome arising from the ” cooperation” of both countries. From this perspective, monetary union is viewed as a cooperative outcome requiring joint action for its construction and its stability.

World Economy with Local Currencies

We consider an overlapping generations structure in which all agents live for two periods.6 The horizon is infinite with time indexed by t = 1, 2,…..

Further, there are two islands, ” home” and ” foreign”, which axe identical. There is trade across these islands (explained in detail below) but labor is immobile. Each island’s government issues its local currency and imposes that local good is traded through the use of this currency. This corresponds to the imposition by each government of a local currency cash-in-advance constraint.

Before proceeding, it is useful to relate the key components of our model to the underlying discussion of the gains to monetary union. While the model could certainly be extended to capture production using imported inputs, nominal assets other than fiat money and so forth, as it currently stands the model does include the main ingredients needed for an analysis of monetary union. In particular, the model emphasizes; (i) trade and financial interdependence between countries, (ii) the existence of nominal assets and (iii) the presence of trading frictions that could be alleviated through the creation of a common currency.

The analysis will first focus on the optimization problem of a representative agent on the home island. The next subsection looks at maxket clearing. We then characterize the monetary steady state. The main proposition of this section shows that equilibrium inflation rates are positive.

Basic Model

Optimization

The optimization problem of a representative, generation t home agent is given by:
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In (1), the superscript h refers to the home country and / to the foreign country. Old age utility from consumption is a sum of two terms, (9 ln(c^+1) 4-(1 — 9) ln(cf+1)),where c£+1 is the consumption of good j — h, f in period t +1. The level of work, given by nt) is between zero and one as each agent has a unit endowment of time. The disutility of work is represented by g(nt) which is assumed to be increasing, convex and continuously differentiable. For simplicity, we assume that output is equal to input so that the agent produces nt units of goods from this same level of labor input. The variables Pt and pi are the prices of goods h and /, denominated in Home currency and Foreign currency, respectively.

The random variable 9 represents a shock to the tastes of the agent with high values of 9 increasing the utility flow from the consumption of the home good. We assume that 9 e (0,1) and all agents on both islands draw from the same distribution given by H(9). Let 9 be the mean value of this random variable. Realizations of this shock are independent across agents and islands. Hence this is a purely idiosyncratic taste shock. Electronic Payday Loans Online