We analyze a strategic game where in a first step, a country can adopt another country's currency. In a second step, thee two countries commit resources to economic integration. A common currency reduces the overall resource costs of economic integration, but imposes an idiosyncratic adjustment cost on the country changing its currency. A country's currency choice depends on how, favorably or adversely, it expects the other country to respond to a currency change. We find that economic integration without a common currency is a subgame perfect equilibrium outcome. Economic integration with a common currency is another, superior subgame perfect equilibrium outcome.

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May 1995     Paper Number CEPDP0207