A Theory of International Currency and Seigniorage Competition∗

This paper explicitly considers strategic interaction between governments to study currency competition and its effects on the circulation of currencies and welfare in a two-country, twocurrency search theoretic model. Each government uses seigniorage to provide public goods. Agents consume private goods, and the public goods of their own country. We have several Þndings. The negative impact of a country’s inßationary policy on the realm of circulation of its currency imposes an inßation discipline: the more open a country is, the stronger is the discipline. The worldwide circulation of a currency increases seigniorage and welfare and decreases the inßation rate of the issuing country compared to autarky. The other country, since the tax base is reduced due to the use of foreign currency, raises its inßation rate. However, there is a limit on the rate beyond which it cannot maintain the circulation of national money. Under strategic interaction between governments in selecting equilibrium, the larger country would try to lower the inßation rate to make its currency circulate abroad, while the other country may also lower the inßation rate to sustain its national currency as the sole medium of exchange.