In a common currency area (CCA) national governments delegate monetary policy decisions to a supra-national authority, the Common Central Bank (CCB). The CCB sets a uniform rate of inflation across countries, taking into account the area’s economic conditions. Suppose that countries in recession favor a more expansionary policy than countries in expansion. Then if national business cycles are not fully synchronized, a conflict of interest between members arises.
When governments of member countries have an informational advantage over the state of their domestic economy, such conflict may create an adverse selection problem: national authorities overemphasize their shocks in order to shape the common policy towards their needs. Ignoring the problem can be extremely costly, since the CCB may end up inappropriately implementing ”stop and go” policies that add to inflation variability.
This informational problem magnifies the one-policy fits-all inefficiency discussed in the optimal currency area literature. The paper’s main result is that, in a currency area with asymmetric information, the optimal monetary policy must over-react to large symmetric shocks and under-react to asymmetric ones of unequal size. Overall, asymmetric information aggravates the problem of tailoring the policy response to the state of the union’s economy, and causes a welfare loss, that is increasing in the number of member countries. We also show that disregarding some of the information reported by national authorities and adopting a ”rule of thumb” is never efficient, although this rule closely mimic the optimal rule when large shocks are either very rare or very frequent.
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Asymmetric Information and Monetary Policy in Common Currency Areas
