Currency Areas and Monetary Coordination

We analyze the gain from coordinating on inflation between currency areas. To do so, we integrate a monetary search model into open-economy macro to construct a microfoundation for exchange rates. Each currency derives a value from alleviating the difficulties in trade. With a matching process in the goods market that exhibits local congestion, we determine the exchange rate between the currencies and the size of each currency area endogenously. Search frictions generate deviations from the law of one price, despite the fact that prices are perfectly flexible and goods produced by different countries are perfectly substitutable. Because these deviations depend on the cross-country differential in money growth, each country is tempted to inflate to exploit the deviations. Thus, when countries set money growth in a non-cooperative game, inflation is higher than the socially optimal level. Monetary coordination reduces inflation and improves welfare for all countries. Moreover, in contrast to traditional models, the gain from monetary coordination continues to exist even after each country optimally sets a direct tax on the foreign use of the country's currency