Introduction

The possibility of European monetary integration has been frequently discussed in the past few decades; see for example the volumes edited by Fratianni and Peeters (1979), Johnson and Swoboda (1973), Salin (1984), and Masera and Triffin (1984). Much of the debate derives from the theory of optimum currency areas originally proposed by Mundell (1961) and extended by McKinnon (1963) (see also a useful recent discussion in Wood, 1986). More generally, Fischer (1983) provides an enlightening commentary on the problems involved. While interesting issues have emerged, the literature has remained informal, with few attempts to provide a systematic foundation on which to base arguments for and against common currency.

Our purpose in writing this paper is to present a formal two-country general equilibrium framework in which the question of alternative monetary systems can be addressed, in the spirit of Helpman (1981) and Helpman and Razin (1982). We are especially interested in contrasting three monetary regimes, flexible exchange rates, a common currency issued autonomously by both countries, and a common currency whose management is delegated to a jointly controlled central bank. Flexible exchange rates are the appropriate reference case, since they will prevail whenever either country deviates from the common currency agreement. We keep our model very simple, especially in that we assume complete information and consider only the case of two countries. As an added simplification we summarize each country's welfare in terms of a single representative citizen.