External Trade and Monetary Policy in a Currency Area

65 Pages Posted: 12 May 2010

Date Written: January 11, 2010

Abstract

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.

Keywords: Monetary union, optimal monetary policy, loss function

JEL Classification: E52, F41

Suggested Citation

Cecioni, Martina, External Trade and Monetary Policy in a Currency Area (January 11, 2010). Bank of Italy Temi di Discussione (Working Paper) No. 738, Available at SSRN: https://ssrn.com/abstract=1601934 or http://dx.doi.org/10.2139/ssrn.1601934

Martina Cecioni (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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