Bargaining for the Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model

This paper focuses on two questions. First, under what conditions would two countries agree to hold their bilateral cross exchange rate fixed? and second, what allocation of intervention duties would this require? Answers to these questions are sought by combining a standard macroeconomic model of an open economy with the solution concepts of fixed-threat bargaining games. It is shown that for reasonable parameter values the core of the bargaining game implied by this set-up is non-empty, so that an agreed-upon and mutually beneficial allocation of intervention duties exists. Conditions for the non-emptiness of the core as well as the properties of the Nash solution are discussed and the results are used to characterize the difference between a monetary union and a fixed exchange rate regime. It is argued that a fixed exchange rate system in which the bargaining solution requires an asymmetric allocation of intervention duties cannot be an intermediate phase in the transition towards a monetary union.