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Monetary integration and inßation preferences: a real options analysis

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Niveau: Supérieur, Doctorat, Bac+8
Monetary integration and inßation preferences: a real options analysis Frank Strobel? Department of Economics University of Birmingham Birmingham B15 2TT, U.K. Draft version: December 19, 2002 Abstract We use a two-country model where policymakers minimize Barro- Gordon-type loss functions over inßation, and inßation preferences fol- low geometric Brownian motions, to characterize and solve the optimal stopping problem describing a given country?s decision of whether or not to pursue monetary integration with the other one, and derive the conditions under which monetary integration can, or will never, be an equilibrium outcome in our economy. We then carry out compara- tive statics analysis on the bounds characterizing these conditions and on the range of relative inßation preference parameters that support monetary integration in equilibrium, and illustrate with numerical ex- amples. Keywords: monetary integration; inßation preference; real option JEL classi?cation: E5, F3 ?Helpful comments by Harald Uhlig and an anonymous referee are gratefully acknowl- edged. 1

  • low geometric

  • integration can

  • union

  • over inßation

  • ßation preferences

  • monetary integration

  • union-wide inßation

  • process addresses

  • options nature


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Monetary integration and inßationpreferences: a real options analysis
Frank StrobelDepartment of EconomicsUniversity of BirminghamBirmingham B15 2TT, U.K.Draft version: December 19, 2002
AbstractWe use a two-country model where policymakers minimize Barro-Gordon-type loss functions over inßation, and inßation preferences fol-low geometric Brownian motions, to characterize and solve the optimalstopping problem describing a given countrys decision of whether ornot to pursue monetary integration with the other one, and derive theconditions under which monetary integration can, or will never, bean equilibrium outcome in our economy. We then carry out compara-tive statics analysis on the bounds characterizing these conditions andon the range of relative inßation preference parameters that supportmonetary integration in equilibrium, and illustrate with numerical ex-amples.Keywords: monetary integration; inßation preference; real optionJEL classiÞcation: E5, F3Helpful comments by Harald Uhlig and an anonymous referee are gratefully acknowl-edged.
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1 IntroductionWhen countries (or regions) evaluate the potential advantages of forming orjoining a monetary union and their preferences over inßation dier, conven-tional wisdom suggests that any one of them will generally beneÞt from givingup monetary independence if the resulting unions preferences are at least asinßation averse as its own.1This simplistic view is, however, at odds withthe growing literature on irreversible investment under uncertainty, whichhas shown that the decision to invest in an irreversible project with uncer-tain payos can be profoundly aected when that investment can be delayed,as the (real) option of waiting then typically has positive value and needs tobe accounted for.2Several papers in the literature have started to apply this real-optionsmethodology to a countrys decision of whether or not to proceed with mon-etary integration (or disintegration) when inßation preferences are stochasticand such a move is interpreted as largely irreversible.3Strobel (2000) usesa simple two-country model where policymakers minimize a Barro-Gordon-type loss function over inßation to examine the value of the option of mon-etary integration when the national preference parameters associated withan inßationary surprise follow geometric Brownian motions. Deriving an-alytically the critical level of the ratio of these parameters that triggers amove to monetary integration, itÞnds that a country will be willing to giveup monetary independence only if the other country is valuing inßationarysurprises strictly, and potentially substantially, less than itself. The maindrawbacks of that paper are the strictly partial nature of its framework,which critically implies that monetary integration is never actually an equi-librium outcome there, and the fact that countrys weights in the determi-nation of the union-wide inßation preference are restricted to a symmetric1This abstracts from the other potential costs and beneÞts of monetary integration; seee.g. De Grauwe (2000), Gros/Thygesen (1998).2See e.g. Dixit (1992), Pindyck (1991) or, more comprehensively, Dixit/Pindyck (1994).3The growing political economy literature on the break-up of nations (see e.g.Bolton/Roland/Spolaore (1996), Bolton/Roland (1997) or Fidrmuc (1999)) focusses onrelated issues without, so far, taking the real-options nature of a secession decision intoaccount when its payos are uncertain and a degree of irreversibility applies.
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