Currency Areas and Monetary Coordination ∗

Abstract

In this paper we examine currency areas and monetary policy coordination in a two-country model where the value of each country’s currency is determined endogenously. Exchanges in the goods markets are modelled as random bilateral matches, and households choose the amount and the frequency of purchases made in each currency area. By contrast, the currency market is centralized and Walrasian. We determine the nominal exchange rate in the equilibrium and show that the size of a currency area decreases with the growth rate of that currency and increases with the growth rate of the competing currency. We also find the following welfare results on monetary competition and coordination. First, policy coordination results in the Friedman rule being chosen for each currency. Second, policy competition increases inflation and reduces welfare in both countries relative to policy coordination. Third, under policy competition, the incentive to inflate increases with the degree of the integration of the goods markets. Fourth, currency unification delivers the same allocation as policy coordination, provided that the latter can be achieved. Preliminary. Do not quote. Please send comments to eithe