| This paper studies the impact of a common monetary policy in the context of a two-country, general equilibrium limited participation model with liquidity effect and nominal wage contracts, heterogeneous agents, imperfect competition in the labor market, trade in goods, immobility of labor and perfect mobility of capital. Monetary policies respond to deviations in the inflation rate in relation to a targeted level. There are two regimes: a national currencies regime with a floating exchange rate and national monetary authorities who maximize national welfare when choosing the value for the policy reaction parameter; and a single currency regime with a common monetary authority that maximizes aggregate welfare when deciding how much to react to area-wide inflation. In both regimes, the monetary policy instrument is the discount rate of the central bank. The model is solved using Gauss-Hermite quadrature to approximate conditional expectations functions and (over-identified) Chebyshev collocation to approximate optimal policy functions. Considering different types of shocks, both in their nature (technological, monetary and preference shocks), and in their distribution across agents (idiosyncratic versus common shocks), I analyze which types of shocks induce positive and negative welfare changes when switching from national currencies to a single currency, which of these imply a greater gain from switching regimes, and in which case gains from monetary policy are the greatest. According with intuition and for the most part, I find that the national currencies regime is preferred if shocks are predominantly idiosyncratic, while if shocks are mostly common agents are better off under the single currency regime. The highest welfare cost is induced by a common technological shock for national currencies, and by an idiosyncratic shock for the single currency. I also find that the gains of the monetary policy are smaller in the single currency than for the national currencies regime. |
