Commitment and the Adoption of a Common Currency

In contrast to Mundell's inquiry on the optimality of currency areas, this article aims to understand under what circumstances a Pareto-dominant monetary union will be established. Using a multicountry overlapping generations model, we highlight gains from monetary union arising from reduced transactions costs and lower inflation. Despite these gains, countries acting independently will impose barriers to exchange through local currency restrictions, thereby creating transactions costs and providing an incentive for inflation. Therefore, the gains from monetary union are most likely to be lost without collective effort. Copyright 2003 By The Economics Department Of The University Of Pennsylvania And Osaka University Institute Of Social And Economic Research Association