SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: This paper analyses how optimal policy responses to productivity shocks change when the government loses the exchange rate as a policy tool after entering a monetary union. It is shown that over the business cycle (generated as cyclical changes in productivity), both deficit and inflation will be more volatile when there is no exchange rate to support the stabilization policies. The reason is that the exchange rate is quite an efficient weapon in addressing the impact on the price level from the different shocks. Losing it therefore makes prices less stable and triggers a more extensive response in the only policy tool left, the deficit. With respect to unemployment, the outcome depends on the source of the asymmetric shock. If the government dislikes fluctuations in the unemployment rate, and supply shocks are mainly domestic in origin, a monetary union is preferable. If supply shocks are instead mainly foreign in origin, unemployment is less volatile under a flexible exchange rate regime.

Keywords: Asymmetric shocks; monetary union; stabilization policy; reaction function.

JEL-codes: E31; E52; E63

45 pages, January 27, 1999

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