| A model of a dependent central bank that internalizes the government’s budget constraint is used to examine the optimal composition of the euro zone. The model embodies the desire to stimulate output and to provide monetary financing to governments. Unable to pre-commit to first-best policies, the central bank produces excess inflation — a tendency partially reduced in a monetary union. On the basis of this framework, calibrated to euro zone data, the current membership is shown not to be optimal: other members would benefit from the expulsion of several countries, notably Greece, Italy, and France. A narrow monetary union centered around Germany might be able to guarantee central bank independence, but simulation results suggest that such a narrow monetary union would not be in Germany’s interest relative to a return to the deutsche mark. |
Abstract
|
