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

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  • Stéphane AURAY
  • Aurélien EYQUEM

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 when the form of the monetary policy is modified.

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Bibliographic Info

Article provided by ENSAE in its journal Annals Of Economics and Statistics.

Volume (Year): (2013)
Issue (Month): 109-110 ()
Pages: 9

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Handle: RePEc:adr:anecst:y:2013:i:109-110:p:9

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  1. Jinill Kim & Sunghyun Henry Kim, 1999. "Spurious Welfare Reversals in International Business Cycle Models," Virginia Economics Online Papers 319, University of Virginia, Department of Economics.
  2. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2755, C.E.P.R. Discussion Papers.
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  7. Jinill Kim & Sunghyun Henry Kim & Andrew Levin, 2001. "Patience, persistence and welfare costs of incomplete markets in open economies," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 696, Board of Governors of the Federal Reserve System (U.S.).
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  11. Guillermo A. Calvo, 1983. "Staggered Contracts and Exchange Rate Policy," NBER Chapters, National Bureau of Economic Research, Inc, in: Exchange Rates and International Macroeconomics, pages 235-258 National Bureau of Economic Research, Inc.
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  14. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
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