Speculative Attacks on Debts and Optimum Currency Area: A Welfare Analysis

Abstract

Resorting to an extension of the debt crisis model of Cole and Kehoe (JIE 1996), we evaluate financial aspects of an optimum currency area. Our focus is to appraise the welfare of a country, which belongs to a monetary union and might suffer a speculative attack on its public debt. A default may be avoided by an inflation tax on common-currency debt, but this decision depends on majority voting and have costs associated with it. Moreover, the model considers symmetry between national and central governments' decisions about inflation and also describes the loss in international bankers' confidence towards one country being passed on to another. One of our results is that, for a country with low weight in the voting system, common-currency regime is superior in terms of expected welfare to dollarization and may be a better choice than the local-currency one, as the central bank under the latter regime undergoes some political influence from its government.