The Inherent Benefit of Monetary Unions

58 Pages Posted: 1 Aug 2016

See all articles by Dominik Groll

Dominik Groll

Kiel Institute for the World Economy

Tommaso Monacelli

Bocconi University - Department of Economics

Date Written: July 2016

Abstract

The desirability of flexible exchange rates is a central tenet in international macroeconomics. We show that, with forward-looking staggered pricing, this result crucially depends on the monetary authority's ability to commit. Under full commitment, flexible exchange rates generally dominate a monetary union (or fixed exchange rate) regime. Under discretion, this result is overturned: a monetary union dominates flexible exchange rates. By fixing the nominal exchange rate, a benevolent monetary authority finds it welfare improving to tradeoff flexibility in the adjustment of the terms of trade in order to improve on its ability to manage the private sector's expectations. Thus, inertia in the terms of trade (induced by a fixed exchange rate) is a cost under commitment, whereas it is a benefit under discretion, for it acts like a commitment device.

Keywords: commitment, discretion, flexible exchange rates, monetary union, nominal rigidities., welfare losses

JEL Classification: E52, F33, F41

Suggested Citation

Groll, Dominik and Monacelli, Tommaso, The Inherent Benefit of Monetary Unions (July 2016). CEPR Discussion Paper No. DP11416. Available at SSRN: https://ssrn.com/abstract=2816842

Dominik Groll (Contact Author)

Kiel Institute for the World Economy ( email )

P.O. Box 4309
Kiel, D-24100
Germany

Tommaso Monacelli

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

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