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External trade and monetary policy in a currency area

  • Martina Cecioni

    ()

    (Bank of Italy, Economics, Research and International Relations)

For historical and geographical reasons, the member countries of the European Monetary Union (EMU) display different degrees of external trade openness. The paper lays out a model for a currency area composed of two regions. One region is more open to trade with a third country outside the area than the other. Using the utility-based loss function for the currency area, the optimal monetary policy is compared to the one for a homogeneous area. In the model with heterogeneity, the relative competitiveness across regions influences the extent to which shocks are transmitted to the area-wide inflation and output gap. Under a plausible calibration for the EMU, the optimal policy plan exhibits a stronger tendency towards currency area exchange rate stabilization than the one in the homogeneity case. Moreover, it is welfare-improving to forgo some area-wide inflation stabilization to dampen inflation differentials.

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File URL: http://www.bancaditalia.it/pubblicazioni/temi-discussione/2010/2010-0738/en_tema_738.pdf
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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 738.

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Date of creation: Jan 2010
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Handle: RePEc:bdi:wptemi:td_738_10
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  1. Angeloni, Ignazio & Ehrmann, Michael, 2004. "Euro area inflation differentials," Working Paper Series 0388, European Central Bank.
  2. Faia, Ester & Monacelli, Tommaso, 2006. "Optimal Monetary Policy in a Small Open Economy with Home Bias," CEPR Discussion Papers 5522, C.E.P.R. Discussion Papers.
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  4. Ferrero, Andrea, 2009. "Fiscal and monetary rules for a currency union," Journal of International Economics, Elsevier, vol. 77(1), pages 1-10, February.
  5. Benigno, Pierpaolo & Woodford, Michael, 2006. "Linear-Quadratic Approximation of Optimal Policy Problems," CEPR Discussion Papers 5964, C.E.P.R. Discussion Papers.
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  7. Philip Lane & Patrick Honohan, 2005. "Exchange Rates and Inflation under EMU: An Update," The Institute for International Integration Studies Discussion Paper Series iiisdp031, IIIS.
  8. Jeffrey A. Frankel, 2009. "The estimated effects of the euro on trade: why are they below historical effects of monetary unions among smaller countries?," LSE Research Online Documents on Economics 53362, London School of Economics and Political Science, LSE Library.
  9. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  10. Bianca De Paoli, 2004. "Monetary Policy and Welfare in a Small Open Economy," CEP Discussion Papers dp0639, Centre for Economic Performance, LSE.
  11. Patrick Honohan & Philip R. Lane, 2003. "Divergent inflation rates in EMU," Economic Policy, CEPR;CES;MSH, vol. 18(37), pages 357-394, October.
  12. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  13. Alejandro Micco & Ernesto Stein & Guillermo OrdoÒez, 2003. "The currency union effect on trade: early evidence from EMU," Economic Policy, CEPR;CES;MSH, vol. 18(37), pages 315-356, October.
  14. Pau Rabanal, 2009. "Inflation Differentials between Spain and the EMU: A DSGE Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1141-1166, 09.
  15. Andrés, Javier & Ortega, Eva & Vallés, Javier, 2008. "Competition and inflation differentials in EMU," Journal of Economic Dynamics and Control, Elsevier, vol. 32(3), pages 848-874, March.
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