Hostname: page-component-848d4c4894-pjpqr Total loading time: 0 Render date: 2024-06-20T05:01:54.445Z Has data issue: false hasContentIssue false
  • English
  • Français

Monetary policy and welfare in a currency union

Published online by Cambridge University Press:  11 April 2022

Lucio D’Aguanno
Lucio D’Aguanno*
Affiliation:
Bank of England, Threadneedle Street, London, EC2R 8AH, UK
*
Email: lucio.daguanno@bankofengland.co.uk
Get access Rights & Permissions [Opens in a new window]

Abstract

I explore the welfare implications of currency union (CU) membership in a model that generates a trade-off between alternative monetary arrangements. While national currencies support country-specific monetary policies, a CU eliminates some barriers to trade and transitory cross-border price misalignments caused by nominal rigidities. I quantify the welfare gap between these two arrangements and show that it depends crucially on the correlation of shocks across the countries involved. I estimate the model with data from 11 Eurozone members and I seek the minimum trade gains needed to make a single currency worthwhile for them. I find that modest trade gains are likely to be sufficient, given the good business-cycle affiliation of these economies.

Keywords

Currency unionincomplete marketsnominal rigiditieslocal currency pricingtrade frictions
Type
Articles
Information
Macroeconomic Dynamics , Volume 27 , Issue 4 , June 2023 , pp. 1089 - 1114
Copyright
© The Author(s), 2022. Published by Cambridge University Press

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

This paper is a revised version of the second chapter of my doctoral dissertation written at the University of Warwick. The views expressed are solely those of the author and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee, Financial Policy Committee, or Prudential Regulation Committee. I am grateful to Roberto Pancrazi and Marcus Miller for their guidance. I thank Thijs van Rens, Marija Vukotić, Michael McMahon, Juan Carlos Gozzi, Federico Di Pace and seminar participants at the Warwick Macro and International Economics Workshop, the 41st Simposio of the Spanish Economic Association, the Federal Reserve Bank of Boston, the Bank of Spain, the Bank of England and Birkbeck, and University of London for insightful comments on an earlier version of this work. My gratitude extends to Herakles Polemarchakis and Giovanni Ricco for valuable suggestions. This research did not receive any specific grant from funding agencies in the public, commercial, or non-for-profit sectors.

References

Adjemian, S., Bastani, H., Juillard, M., Karamé, F., Mihoubi, F., Perendia, G., Pfeifer, J., Ratto, M. and Villemot, S. (2011) Dynare: Reference manual, version 4. Dynare Working Papers 1.Google Scholar
Angeloni, I., Aucremanne, L. and Ciccarelli, M. (2006) Price setting and inflation persistence: Did EMU matter? Economic Policy 21(46), 354–387.CrossRefGoogle Scholar
Artis, M. J. and Zhang, W. (1999) Further evidence on the international business cycle and the ERM: Is there a European business cycle? Oxford Economic Papers 51(1), 120–132.CrossRefGoogle Scholar
Bacchetta, P. and van Wincoop, E. (2000) Does exchange-rate stability increase trade and welfare? American Economic Review 90(5), 1093–1109.CrossRefGoogle Scholar
Beetsma, R. and Jensen, H. (2005) Monetary and fiscal policy interactions in a micro-founded model of a monetary union. Journal of International Economics 67(2), 320–352.CrossRefGoogle Scholar
Benigno, P. (2004) Optimal monetary policy in a currency area. Journal of International Economics 63(2), 293–320.CrossRefGoogle Scholar
Benigno, P. (2009) Price stability with imperfect financial integration. Journal of Money, Credit and Banking 41(S1), 121–149.CrossRefGoogle Scholar
Bhattarai, S., Lee, J. W. and Park, W. Y. (2015) Optimal monetary policy in a currency union with interest rate spreads. Journal of International Economics 96(2), 375–397.CrossRefGoogle Scholar
Campolmi, A. and Faia, E. (2011) Labor market institutions and inflation volatility in the Euro area. Journal of Economic Dynamics and Control 35(5), 793–812.CrossRefGoogle Scholar
Ching, S. and Devereux, M. B. (2003) Mundell revisited: A simple approach to the costs and benefits of a single currency area. Review of International Economics 11(4), 674–691.CrossRefGoogle Scholar
Clarida, R., Galí, J. and Gertler, M. (2002) A simple framework for international monetary policy analysis. Journal of Monetary Economics 49(5), 879–904.CrossRefGoogle Scholar
Corden, W. M. (1972) Monetary integration. Princeton Essays in International Finance 93. Google Scholar
Corsetti, G., Dedola, L. and Leduc, S. (2008) International risk sharing and the transmission of productivity shocks. Review of Economic Studies 75(2), 443–473.CrossRefGoogle Scholar
Corsetti, G., Dedola, L. and Leduc, S. (2011) Optimal monetary policy in open economies. In: Friedman, B. and Woodford, M. (eds.), Handbook of Monetary Economics, Volume 3. Elsevier.Google Scholar
Corsetti, G. and Pesenti, P. (2001) Welfare and macroeconomic interdependence. Quarterly Journal of Economics 116(2), 421–445.CrossRefGoogle Scholar
Crespo Cuaresma, J., Égert, B. and Silgoner, M. A. (2007) Price level convergence in Europe: Did the introduction of the euro matter? Monetary Policy & The Economy Q1(07), 100–113.Google Scholar
De Paoli, B. (2009) Monetary policy under alternative asset market structures: The case of a small open economy. Journal of Money, Credit and Banking 41(7), 1301–1330.CrossRefGoogle Scholar
Devereux, M. B. and Engel, C. (2003) Monetary policy in the open economy revisited: Price setting and exchange-rate flexibility. Review of Economic Studies 70(4), 765–783.CrossRefGoogle Scholar
Devereux, M. B., Engel, C. and Tille, C. (2003) Exchange rate pass-through and the welfare effects of the Euro. International Economic Review 44(1), 223–242.CrossRefGoogle Scholar
Dhyne, E., L. J. Álvarez, Bihan, H. L., Veronese, G., Dias, D., Hoffmann, J., Jonker, N., Lünnemann, P., Rumler, F., Vilmunen, J. (2005). Price setting in the euro area: Some stylized facts from individual consumer price data. ECB Working Paper Series 524.Google Scholar
Duarte, M. and Obstfeld, M. (2008) Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored. Journal of International Money and Finance 27(6), 949–957.CrossRefGoogle Scholar
Engel, C. (2000) Local-currency pricing and the choice of exchange-rate regime. European Economic Review 44(8), 1449–1472.CrossRefGoogle Scholar
Engel, C. (2011) Currency misalignments and optimal monetary policy: A reexamination. American Economic Review 101(6), 2796–2822.CrossRefGoogle Scholar
Engel, C. (2014) Exchange rate stabilization and welfare. Annual Review of Economics 6(1), 155–177.CrossRefGoogle Scholar
Engel, C. and Rogers, J. H. (2001) Deviations from purchasing power parity: Causes and welfare costs. Journal of International Economics 55(1), 29–57.CrossRefGoogle Scholar
Engel, C. and Rogers, J. H. (2004) European product market integration after the euro. Economic Policy 19(39), 347–384.CrossRefGoogle Scholar
Erceg, C., Gust, C. and López-Salido, D. (2009) The transmission of domestic shocks in open economies. In: J. Galí and M. Gertler (eds.), International Dimensions of Monetary Policy. National Bureau of Economic Research, University of Chicago Press.CrossRefGoogle Scholar
Fatás, A. (1998) Does EMU need a fiscal federation? Economic Policy 13(26), 163–203.CrossRefGoogle Scholar
Feldstein, M. (2015) Ending the euro crisis. Journal of Policy Modeling 37(3), 423–427.CrossRefGoogle Scholar
Ferrero, A. (2009) Fiscal and monetary rules for a currency union. Journal of International Economics 77(1), 1–10.CrossRefGoogle Scholar
Forlati, C. (2009). Optimal monetary and fiscal policy in the EMU: Does fiscal policy coordination matter? EPFI CFI Center for Fiscal Policy Working Paper 04.CrossRefGoogle Scholar
Frankel, J. (2015) The euro crisis: Where to from here? Journal of Policy Modeling 37(3), 428–444.CrossRefGoogle Scholar
Frankel, J. A. and Rose, A. K. (1998) The endogeneity of the optimum currency area criteria. The Economic Journal 108(449), 1009–1025.CrossRefGoogle Scholar
Galí, J., Gertler, M. and López-Salido, D. (2001) European inflation dynamics. European Economic Review 45(7), 1237–1270.CrossRefGoogle Scholar
Galí, J., Gertler, M. and López-Salido, D. (2003) Erratum to "European inflation dynamics”. European Economic Review 47(4), 759–760.CrossRefGoogle Scholar
Galí, J. and Monacelli, T. (2005) Monetary policy and exchange rate volatility in a small open economy. Review of Economic Studies 72(3), 707–734.CrossRefGoogle Scholar
Hall, R. E. (1988) Intertemporal substitution in consumption. Journal of Political Economy 96(2), 339–357.CrossRefGoogle Scholar
Ingram, J. C. (1973) The case for European monetary integration, Princeton Essays in International Finance 98. Google Scholar
Kim, J. and Kim, S. H. (2003) Spurious welfare reversals in international business cycle models. Journal of International Economics 60(2), 471–500.CrossRefGoogle Scholar
Kim, J., Kim, S. H., Schaumburg, E. and Sims, C. A. (2008) Calculating and using second-order accurate solutions of discrete time dynamic equilibrium models. Journal of Economic Dynamics and Control 32(11), 3397–3414.CrossRefGoogle Scholar
Kollman, R. (2004) Welfare effects of a monetary union: The role of trade openness. Journal of the European Economic Association 2(2–3), 289–301.CrossRefGoogle Scholar
Krippner, L. (2015) Zero Lower Bound Term Structure Modeling, Palgrave Macmillan.CrossRefGoogle Scholar
Lama, R. and Rabanal, P. (2014) Deciding to enter a monetary union: The role of trade and financial linkages. European Economic Review 72(2), 138–165.CrossRefGoogle Scholar
Lucas, R. E. (1987) Models of Business Cycles. Basil Blackwell.Google Scholar
McKinnon, R. I. (1963) Optimum currency areas. American Economic Review 53(4), 717–725.Google Scholar
Meyer-Gohde, A. (2010) Matlab code for one-sided HP-filters. Quantitative Macroeconomics and Real Business Cycles Codes 181.Google Scholar
Mundell, R. (1961) A theory of optimum currency areas. American Economic Review 51(4), 657–665.Google Scholar
Obstfeld, M. and Peri, G. (1998) Regional non-adjustment and fiscal policy. Economic Policy 13(26), 205–259.CrossRefGoogle Scholar
Rogers, J. H. (2007) Monetary union, price level convergence, and inflation: How close is Europe to the USA? Journal of Monetary Economics 54(3), 785–796.CrossRefGoogle Scholar
Rose, A. (2000) One money, one market: The effect of common currencies on trade. Economic Policy 15(30), 7–45.CrossRefGoogle Scholar
Rose, A. and van Wincoop, E. (2001) National money as a barrier to international trade: The real case for currency union. American Economic Review 91(2), 386–390.CrossRefGoogle Scholar
Santos-Silva, J. and Tenreyro, S. (2010) Currency unions in prospect and retrospect. Annual Review of Economics 2(1), 51–74.CrossRefGoogle Scholar
Schmitt-Grohé, S. and Uribe, M. (2012) What’s news in business cycles. Econometrica 80(6), 2733–2764.Google Scholar
Schmitt-Grohé, S. and Uribe, M. (2013) Downward nominal wage rigidity and the case for temporary inflation in the eurozone. Journal of Economic Perspectives 27(3), 193–212.CrossRefGoogle Scholar
Smets, F. and Wouters, R. (2007) Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review 97(3), 586–606.CrossRefGoogle Scholar
Wu, J. C. and Xia, F. D. (2016) Measuring the macroeconomic impact of monetary policy at the zero lower bound. Journal of Money, Credit and Banking 48(2-3), 253–291.CrossRefGoogle Scholar