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Deciding to Enter a Monetary Union

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  • Ruy Lama
  • Pau Rabanal

Abstract

This paper evaluates the role of trade and financial linkages in the decision to enter a monetary union. We estimate a two-country DSGE model for the U.K. economy and the euro area, and use the model to compute the welfare trade-offs from joining the euro. We evaluate two alternative scenarios. In the first one, we consider a reduction of trade costs that occurs after the adoption of a common currency. In the second, we introduce interest rate spread shocks of the same magnitude as the ones observed during the recent debt crisis in Europe. The reduction of trade costs generates a net welfare gain of 0.9 percent of life-time consumption, while the increased interest rate spread volatility generates a net welfare cost of 2.9 percentage points. The welfare calculation suggests two ways to preserve the welfare gains in a monetary union: ensuring fiscal and financial stability that reduces macroeconomic country risk, and increasing wage flexibility such that the economy adjusts to external shocks faster.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 12/240.

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Length: 52
Date of creation: 02 Oct 2012
Date of revision:
Handle: RePEc:imf:imfwpa:12/240

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Keywords: Monetary unions; United Kingdom; European Economic and Monetary Union; Euro Area; Economic integration; Trade integration; Economic models; Trade Costs; DSGE Model; Monetary Union.; intermediate goods; elasticity of substitution; nominal interest rate; exchange rate policy; open economy; trade expansion; imported intermediate; domestic market; monetary policy; international trade; asset market; transactions costs; output growth; exogenous shock; net exports; intermediate inputs; optimum currency areas; monetary fund; imported goods; unit of labor; domestic shocks; trade creation; transport costs; exchange rate mechanism; inflation; european monetary union; dynamic effects; equilibrium model; central bank; trade impediments; competitive position; domestic producers; regulatory policies; asymmetric shocks; aggregate consumption; external shocks; market integration; member country; price stability; exchange rate policies; transmission of shocks; terms of trade; exchange rate risk; domestic goods;

References

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  10. Jordi Galí & Pau Rabanal, 2004. "Technology Shocks and Aggregate Fluctuations," IMF Working Papers 04/234, International Monetary Fund.
  11. James E. Anderson & Eric van Wincoop, 2004. "Trade Costs," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 42(3), pages 691-751, September.
  12. Mazzenga, Elisabetta & Ravn, Morten O., 2002. "International Business Cycles: The Quantitative Role of Transportation Costs," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3530, C.E.P.R. Discussion Papers.
  13. Santos Silva, J.M.C & Tenreyro, Silvana, 2010. "Currency Unions in Prospect and Retrospect," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7824, C.E.P.R. Discussion Papers.
  14. Adolfson, Malin & Laséen, Stefan & Lindé, Jesper & Villani, Mattias, 2005. "Bayesian Estimation of an Open Economy DSGE Model with Incomplete Pass-Through," Working Paper Series 179, Sveriges Riksbank (Central Bank of Sweden).
  15. Thomas Lubik & Frank Schorfheide, 2006. "A Bayesian Look at the New Open Economy Macroeconomics," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 2005, Volume 20, pages 313-382 National Bureau of Economic Research, Inc.
  16. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4334, C.E.P.R. Discussion Papers.
  17. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  18. Sungbae An & Frank Schorfheide, 2007. "Bayesian Analysis of DSGE Models—Rejoinder," Econometric Reviews, Taylor & Francis Journals, Taylor & Francis Journals, vol. 26(2-4), pages 211-219.
  19. Pau Rabanal, 2009. "Inflation Differentials between Spain and the EMU: A DSGE Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 41(6), pages 1141-1166, 09.
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  22. Rabanal, Pau & Tuesta, Vicente, 2010. "Euro-dollar real exchange rate dynamics in an estimated two-country model: An assessment," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 34(4), pages 780-797, April.
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