The independence of the European Central Bank (ECB), seemingly guaranteed by its statutes, is presently under attack. The ECB has been led to acquire large amounts of government debt of the weaker euro zone members, both to help contain their interest costs and to help protect the solvency of banks throughout the zone that hold their debt. This paper presents a model of a dependent central bank that internalizes the government’s budget constraint. Using a Barro-Gordon framework, the model embodies both the desire to stimulate output and to provide monetary financing to governments. As a result of the inability to pre-commit to first-best policies, the central bank produces excess inflation — a tendency partially reduced in a monetary union. The model implies that not only shock asymmetries, but also fiscal asymmetries, are important in the membership calculus of desirable monetary unions. On the basis of this framework, calibrated to euro zone data, the current membership is shown not to be optimal: other members would benefit from the expulsion of several countries, notably Greece, Italy and France. A narrow monetary union centred around Germany is sometimes mooted as a preferable alternative, especially if it could guarantee central bank independence. However, simulation results suggest that such a narrow monetary union would not be in Germany’s interest: though better than the euro zone with a dependent central bank, it would not internalize enough trade to make it more attractive than the resumption of monetary autonomy by Germany.

Paul R. Masson recently retired from the Rotman School of Management, University of Toronto, where he has also taught international finance to graduate students in the economics department. Paul has spent most of his career at official institutions: starting at the Bank of Canada in 1973 after receiving a Ph.D. from the London School of Economics. He then worked at the Organisation for Economic Co-operation and Development and the International Monetary Fund. He is currently associated with the National Bureau of Economic Research, Center for Economic and Policy Research and the C.D. Howe Institute, and was a visiting scholar at The Brookings Institution. During 2007-08, Paul served as special adviser to the Governor of the Bank of Canada. He has also consulted for the Bank for International Settlements, the Conference Board of Canada, the Dubai Economic Council and the World Bank.

Paul’s research interests and publications have mainly been in the area of monetary economics, international money and finance, public finance, and macroeconomic modelling.  He has published several books, including Economic Cooperation in an Uncertain World, with Atish Ghosh (Blackwell, 1994), The Monetary Geography of Africa, with Catherine Pattillo (Brookings Institution Press, 2005), and a textbook based on his course, Topics in International Finance (World Scientific, 2007).  He has also published a number of articles on policy credibility, financial crises, contagion, exchange rate regimes, and financial regulation. A collection of some of his articles has recently appeared under the title Currencies, Crises, Fiscal Policy, and Coordination (World Scientific, 2011).

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