Abstract
The paper considers a monetary union composed of two representative countries characterized by different inflation aversions. The model derives Nash equilibria after a country-specific shock in which the countries have a costly option to abandon the common currency. The main results are that the higher the inflation aversion of the country affected by the shock, the lower its exit probability. The higher the inflation aversion in both countries, the lower the probability that the country not directly hit also abandons the monetary union (contagion).
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Notes
I consider the exchange rate with respect to the rest of the world to be exogenous and equal to 1 in level and 0 in logs. The reason is that the focus is on the instability deriving from the strategic interaction between countries belonging to a monetary union characterized by different levels of inflation aversion. This implies that we can consider the behavior of the rest of the world as given.
We can assume that the exchange rates are equal to 1 in level and 0 in logs if the two countries are in the monetary union. This implies that the exchange rates become positive in case of exit.
In this stylized model, the two countries are symmetric except for their inflation aversion. The relative weight is assumed to be smaller than 1/2. This assumption appears to be reasonable and is crucial in the analytical assessment of the impact of inflation aversion, as explained in the “Role of Inflation Aversion” section.
The only source of inflation here is devaluation.
This cost can also be considered as a proxy for all the costs other than inflation that the country has to sustain when leaving the monetary union (i.e., banking crises, government debt sustainability). δ is simply a dummy variable equal to 1 if the country leaves the monetary union and 0 otherwise.
In this case we set σ = 1, \( \beta =\frac{1}{3} \) and C = 1000.
The inflation aversion of the other country has been set at a level of 0.1.
Here, the assumption \( \beta <\frac{1}{2} \) becomes relevant because it ensures that \( \frac{\partial {v}_2}{\partial \theta } \) is positive as equation (12) shows.
I am grateful to the referee for this comment.
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Acknowledgments
I am grateful to the participants of the International Atlantic Economic Society’s conference in Berlin, 22-25 March 2017, the editor and an anonymous referee of the Atlantic Economic Journal for their very helpful comments and suggestions. I remain solely responsible for any mistakes.
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Canofari, P. Inflation Aversion and Exit Probabilities in the Monetary Unions. Int Adv Econ Res 24, 17–24 (2018). https://doi.org/10.1007/s11294-018-9664-1
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DOI: https://doi.org/10.1007/s11294-018-9664-1