Countries which share a common currency potentially have strong incentives to share macroeconomic risks through a system of transfers to compensate for the loss of national monetary policy. However, the option to leave the currency union and regain national monetary policy can place severe limits on the size and persistence of transfers which are feasible inside the union. In this paper, we derive the optimal transfer policy for a currency union as a dynamic contract subject to enforcement constraints, whereby each country has the option to unpeg from the common currency, with or without default on existing obligations. Our analysis shows that the lack of independent monetary policy, or an equivalent independent policy instrument, limits the extent
of risk-sharing within a currency union; nevertheless, in the latter, the optimal state-contingent transfer policy take as given the optimal monetary policy as to implement a constrained efficient allocation that minimises the losses of the monetary union. At the steady state welfare is lower than in a fiscal union with independent monetary policies. Neverhtless, in our simulations, the
macroeconomic stabilisation effects and the social values achieved, under the two different union regimes, are quantitatively almost the same.