Working paper No. 92
By Marion Kohler
It is well known from the analysis of monetary policy coordination of two countries that coordination often Pareto-dominates the outcome of the non-cooperative game. Hence both countries will have an incentive to form a union when it is certain that the other country will also join.
However, in an n-country model, free-riding incentives restrict the size of a stable coalition to less than n countries. Since the coalition members are bound by the union's discipline, an outsider can successfully export in ination without fearing that the insiders will try to do the same.
The formation of a large currency bloc is not sustainable since it would impose too much discipline on all participants. However, the co-existence of several smaller currency blocs may be a second-best solution to the free-riding problem of monetary policy coordination