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Impact on Welfare of Country Heterogeneity in a Currency Union

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  • Carla Soares

Abstract

We build a two-country DSGE model for a currency union, with habit formation, product and labour differentiation and nominal rigidities, and monetary policy follows an ad-hoc rule. The main innovation is the incorporation of several sources of heterogeneity and the assessment of its impact on welfare. From the formal utility-based welfare analysis, we find that nominal rigidities are the most important source of heterogeneity. In a currency union where the central bank responds area wide and does not take into account national differences, it would be desirable to lower the overall level of rigidity in both countries at the same time, as there are significant welfare losses when country heterogeneity rises. A comparison of different policy rules allows us to conclude that rules that weigh more inflation relatively to the output gap provide the best result in terms of welfare. We also find out that if the central bank can take into account differences in nominal rigidities levels between countries, then it is preferable to react more strongly to the more rigid country.

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Paper provided by Banco de Portugal, Economics and Research Department in its series Working Papers with number w200814.

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Date of creation: 2008
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Handle: RePEc:ptu:wpaper:w200814

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  1. Alexei Onatski & Noah Williams, 2004. "Empirical and policy performance of a forward-looking monetary model," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  2. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  3. Pierpaolo Benigno & Michael Woodford, 2004. "Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State," NBER Working Papers 10839, National Bureau of Economic Research, Inc.
  4. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
  5. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
  6. Ernest Pytlarczyk, 2005. "An Estimated DSGE Model for The German Economy," Computing in Economics and Finance 2005 318, Society for Computational Economics.
  7. Pedro Teles & Isabel Correia & Bernardino Adao, 2007. "On the Relevance of Exchange Rate Regimes for Stabilization Policy," 2007 Meeting Papers 616, Society for Economic Dynamics.
  8. Sandra Gomes, 2004. "Monetary Policy in a Currency Union with National Price Asymmetries," Working Papers w200416, Banco de Portugal, Economics and Research Department.
  9. Mirko Abbritti, 2007. "A "Simple" Currency Union Model with Labor Market Frictions, Real Wage Rigidities and Equilibrium Unemployment," IHEID Working Papers 09-2007, Economics Section, The Graduate Institute of International Studies.
  10. Eric Jondeau & Jean-Guillaume Sahuc, 2008. "Optimal Monetary Policy in an Estimated DSGE Model of the Euro Area with Cross-Country Heterogeneity," International Journal of Central Banking, International Journal of Central Banking, vol. 4(2), pages 23-72, June.
  11. Bernardino Ad�o & Isabel Correia & Pedro Teles, 2004. "The Monetary Transmission Mechanism: Is It Relevant for Policy?," Journal of the European Economic Association, MIT Press, vol. 2(2-3), pages 310-319, 04/05.
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Cited by:
  1. Carla Soares, 2008. "Heterogeneity in a Monetary Union and its Impact on Welfare," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.

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