Monetary integration and inflation preferences: A real options analysis

Frank Strobel, University of Birmingham

Abstract

We use a two-country model where policymakers minimize Barro–Gordon-type loss functions over inflation, and inflation preferences follow 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 comparative statics analysis on the bounds characterizing these conditions and on the range of relative inflation preference parameters that support monetary integration in equilibrium, and illustrate with numerical examples.