On Financial Markets Incompleteness, Price Stickiness, and Welfare in a Monetary Union

Stéphane Auray and Aurélien Eyquem
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Aurélien Eyquem: GATE, UMR 5824, Université de Lyon and Ecole Normale Supérieure Lettres et Sciences Humaines, France

Cahiers de recherche from Departement d'Economique de la Faculte d'administration à l'Universite de Sherbrooke

Abstract: The paper builds a two-country model of a monetary union with home bias and price stickiness. Incompleteness of financial asset markets is allowed. In this environment, we derive the solution for optimal behavior by the monetary policymaker and show that welfare can be higher under incomplete markets than under complete markets. The argument is a second-best one. In a monetary union with equal nominal rigidity across countries, optimal monetary policy stabilizes aggregate, union-wide inflation, but cannot fully stabilize the country-level inflation rates. Market incompleteness results in less volatility of the terms-of-trade (because part of the adjustment goes through the current account), and hence less volatile national inflation rates. Through this channel, welfare ends up being higher under incomplete markets. These results are also robust when nominal rigidity differs across countries and whenthe form of the monetary policy is modified.

Keywords: monetary union; asymmetric shocks; financial market incompleteness; price stickiness; welfare (search for similar items in EconPapers)
JEL-codes: E51 E58 F36 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
Date: 2008-09-09, Revised 2009-09-01
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http://pages.usherbrooke.ca/gredi/wpapers/GREDI-0816.pdf First version, 2008 (application/pdf)

Related works:
Working Paper: On Financial Markets Incompleteness, Price Stickiness, and Welfare in a Monetary Union (2007)
Working Paper: On financial markets inclompleteness, price stickyness and welfare in a monetary union ? (2008)
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Persistent link: http://EconPapers.repec.org/RePEc:shr:wpaper:08-16

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