No. 738 - External trade and monetary policy in a currency area

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.