Asymmetric Shocks in a Currency Union with Monetary and Fiscal Handcuffs

Abstract

This paper investigates the impact of the asymmetric shocks within a currency union in a framework that takes account of the zero bound constraint on policy rates, and also allows for constraints on fiscal policy. In this environment, we document that the usual optimal currency argument showing that the effects of shocks are mitigated to the extent that they are common across member states can be reversed. Countries can be worse off when their neighbors experience similar shocks, including policy-driven reductions in government spending.

Keywords: Monetary policy, fiscal policy, liquidity trap, zero bound constraint, open economy macroeconomics, DSGE model

JEL Classification: E32, F41