A Simple World Model of Monetary Union - A Note

The economic debate about European monetary is often condusted as if the problem were one of choosing between a fixed or a flexible exchange rate syatem (for example, see Sirc (1977)). This approach has been largly unsatisfactory, because it fails to get to grips with the main characteristic of monetary union, which is neither of these two extremes, but is a combination of both pegged exchange rates within the union, and with the union jointly floating against the rest of the world. It is clear that most models analysed in the literature, whether small-open-economy models or even two-country world models, are unable to get a handle on this special feature. In order to characterise monetary union it is necessary to construct a three-country model. I propose in this paper to set up and examine a very simple model of a two-country monetary union which has a floeting exacange-rate with the rest of the world. In this context a monetary union simply involves the pegging of the exchange rate between the member countries and the universally held expectation that the parities will be maintained. It is assumed that the members of the union are large in relation to each other, but the union is small in relation to the rest of the world. These rather unrealistic country-size assumptions have the advantage of keeping the analysis tractable. They allow us to take into account the repercussions within the union, but to abstract from any feedbacks from the union to the rest of the world.