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Impact on Welfare of Country Heterogeneity in a Currency Union

  • Carla Soares

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. Ernest Pytlarczyk, 2005. "An Estimated DSGE Model for The German Economy," Computing in Economics and Finance 2005 318, Society for Computational Economics.
  2. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  3. Bernardino Adão & Isabel Horta Correia & Pedro Teles, 2006. "On the Relevance of Exchange Rate Regimes for Stabilization Policy," Working Papers w200616, Banco de Portugal, Economics and Research Department.
  4. Jondeau, E. & Sahuc, J-G., 2006. "Optimal Monetary Policy in an Estimated DSGE Model of the Euro Area with Cross-country Heterogeneity," Working papers 141, Banque de France.
  5. Bernardino Adao & Isabel Correia & Pedro Teles, 2000. "The Monetary Transmission Mechanism: Is it Relevant for Policy?," Econometric Society World Congress 2000 Contributed Papers 0967, Econometric Society.
  6. 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.
  7. Alexei Onatski & Noah Williams, 2010. "Empirical and policy performance of a forward-looking monetary model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 25(1), pages 145-176.
  8. Benigno, Pierpaolo & Woodford, Michael, 2004. "Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State," CEPR Discussion Papers 4740, C.E.P.R. Discussion Papers.
  9. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  10. 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.
  11. Sandra Gomes, 2004. "Monetary Policy in a Currency Union with National Price Asymmetries," Working Papers w200416, Banco de Portugal, Economics and Research Department.
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