Monetary and fiscal policy in an estimated two country DSGE Model: micro-economic foundations and applications to the euro area and the UK

This paper presents an estimated two-country dynamic stochastic general equilibrium (DSGE) model linking the United Kingdom (UK) and the euro area (EA). The model includes imperfect exchange rate pass-through, external habit formation, producer and importer sticky prices à la Calvo, incomplete markets and local currency pricing (LCP). In addition to monetary policy, the model also introduces fiscal policy by means of a fiscal spending rule. The purpose is to investigate heterogeneity between the UK and the EA by comparing estimated parameters which describe agent’s decision-making and the conduct of monetary and fiscal policy and by exploring the effects and cross-country transmission of a number of structural shocks. Furthermore, the paper aims at contributing to the ongoing debate about whether or not the UK should join the EMU. In this context, it is explored how an entry to the EMU would have affected the UK economy. Overall, the results indicate that both economies are highly homogenous. Furthermore, the UK would in general benefit from a membership. Although with certain shocks more variability in output and inflation was measured, in the presence of a preference shock, a foreign government spending shock, a home and foreign cost-push shock the UK and EMU would gain from an membership.