Currency Unions and International Assistance

This paper considers a simple stochastic model of international trade with three
countries. Two of the tree countries are in an economic union. Comparisons are made
between equilibrium welfare for these two countries under fixed and flexible exchange
rate regimes. Within the model it is shown that flexible exchange rate regimes generate
greater welfare. However, we then consider comparisons of welfare when the two
countries also engage in some international assistance in order to share risk. Such risksharing
is limited by enforcement constraints of cross border assistance. It is shown that,
when one takes into account risk-sharing and limited commitment, fixed exchange rate
regimes associated with a currency area can dominate flexible exchange rate regimes,
which reverses the standard result.