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Currency Competition as a Discipline Device for the Government

In the context of governmental fiscal and monetary policy, currency competition restricts a domestic government's ability to implement its optimal policy via households' choice of currencies. We analyze the currency competition between a domestic and a foreign currency when the government is benevolent but cannot commit to future monetary and fiscal policy. Our first result is that equilibrium falls into one of three regions, depending on the inflation rate on the foreign currency. More specifically, if the foreign currency has intermediate levels of inflation (known as the threat region), it does not circulate, but its existence constrains the government. Our main result is that the threat region always has a sub-region in which the foreign currency improves welfare because the threat of the foreign currency prevents the government from implementing excessively high inflation rates due to its lack of commitment ability.


Macroeconomics, Macroeconomic policy, Public finance

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