Collective Pegging to an External Currency: Lessons from a Three-Country Model

This paper examines the circumstances under which it is beneficial for small countries in a currency union to peg their currency to a large one (euro zone for example). For these purposes, we provide a three-country theoretical model extending the two-country model by Ricci (2008). The theoretical model is based on a Ricardian model of free traded, with specialised economies each producing one traded and one-traded good. We show that when the home country belongs to a monetary union and its exchange rate is anchored to the large country, the stability of its economy depends on the variability of real and monetary shocks for the large country. Furthermore, if the monetary rule in the currency union is higher than the average rate of growth of money supply of large country or if it is difficult to find a monerary rule in the currency union, it is advantageous to anchor the single currency to that of the large country.