What is, compared with the Delors Report objective of achieving European monetary integration by institutional reform, the theoretical case for the United Kingdom Treasury proposal (HM Treasury, 1989) that the determination of the eventual nominal anchor of a unified Europe be left to Darwinian market forces through the removal of obstacles to currency substitution?

This question – crucial from a policy perspective, and challenging from a theoretical standpoint – has recently been addressed by Michael Woodford (1991) in a very skillful and thought-provoking paper. Woodford suggests, in essence, that we make two simplifying assumptions to study currency competition. First, he argues, we should think of currency substitutability as an attribute of preferences, and thus ‘represent’ institutional reforms that increase substitutability of currencies in transactions and portfolios as changes in the utility function, without having to worry about the formalization of institutions themselves. Second, Woodford submits that not much generality is lost by studying currency substitution within the context of an integrated world (or regional) equilibrium with a representative world (or European) consumer, as monetary issues themselves and not the pattern of intra-European trade flows are at the core of the debate on European financial integration.

The two theoretical shortcuts which these assumptions provide allow Woodford to construct a very powerful, but also very complex, model of currency substitution based on an n-good, n-currency cash-in-advance model with linear production. Each good should be thought of as a commodity which must be purchased with a specific currency; the substitutability in utility between the different goods, and the substitutability in utility between labour allocated to the production of each good, indirectly reflect the restrictiveness of institutional barriers to currency substitution.