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WHY JOIN A CURRENCY UNION? A NOTE ON THE IMPACT OF BELIEFS ON THE CHOICE OF MONETARY POLICY

Published online by Cambridge University Press:  18 August 2011

Federico Ravenna
Federico Ravenna*
Affiliation:
Institute of Applied Economics, HEC Montreal and University of California–Santa Cruz
*
Address correspondence to: Federico Ravenna, Institute of Applied Economics—HEC Montreal, 3000, Chemin de la Côte-Sainte-Catherine, Montréal, Québec H3T 2A7, Canada; e-mail: federico.ravenna@hec.ca.
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Abstract

We argue that a fixed exchange rate can be an optimal choice even if a policy maker could commit to the first-best monetary policy whenever the private sector's beliefs reflect incomplete information about the policy maker's dependability. This model implies that joining a currency area may be optimal for its impact not on the behavior of the policy maker, but on the beliefs of the private sector. Monetary policies are evaluated using a new Keynesian model of a small open economy solved under imperfect policy credibility. We quantify the minimum distance between announced policy and the private sector's beliefs that is necessary for a peg to perform better than an independent monetary policy when the policy maker can commit to the first-best policy.

Keywords

Monetary UnionSmall Open EconomyExchange Rate RegimesMonetary PolicyNominal RigiditiesCredibility
Type
Notes
Information
Macroeconomic Dynamics , Volume 16 , Issue 2 , April 2012 , pp. 320 - 334
Copyright
Copyright © Cambridge University Press 2011

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