DP11416 The Inherent Benefit of Monetary Unions

Author(s): Dominik Groll, Tommaso Monacelli
Publication Date: July 2016
Keyword(s): commitment, discretion, flexible exchange rates, monetary union, nominal rigidities, welfare losses
JEL(s): E52, F33, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11416

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.