Monetary Policy and Welfare in a Currency Union

D’Aguanno, Lucio
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D’Aguanno, Lucio: Department of Economics University of Warwick

The Warwick Economics Research Paper Series (TWERPS) from University of Warwick, Department of Economics

Abstract: What are the welfare gains from being in a currency union? I explore this question in the context of a dynamic stochastic general equilibrium model with monetary barriers to trade, local currency pricing and incomplete markets. The model generates a trade off between monetary independence and monetary union. On one hand, distinct national monetary authorities with separate currencies can address business cycles in a countryspecific way, which is not possible for a single central bank. On the other hand, short-run violations of the law of one price and long-run losses of international trade occur if different currencies are adopted, due to the inertia of prices in local currencies and to the presence of trade frictions. I quantify the welfare gap between these two international monetary arrangements in consumption equivalents over the lifetime of households, and decompose it into the contributions of di.erent frictions. I show that the welfare ordering of alternative currency systems depends crucially on the international correlation of macroeconomic shocks and on the strength of the monetary barriers affecting trade with separate currencies. I estimate the model on data from Italy, France, Germany and Spain using standard Bayesian tools, and I find that the trade off is resolved in favour of a currency union among these countries.

Keywords: Currency union; Incomplete markets; Nominal rigidities; Local currency pricing; Trade frictions; Welfare (search for similar items in EconPapers)
JEL-codes: D52 E31 E32 E42 E52 F41 F44 F45 (search for similar items in EconPapers)
Date: 2015
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:wrk:warwec:1082

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