Inflation Targeting Versus Joining a Monetary Union: An Assessment of the Potential Benefits and Costs Using a DSGE Model

This paper uses a DSGE model to study the potential benefits and costs of joining a monetary union. We show that the potential benefits arise from two sources. First, it reduces the magnitude of shocks by eliminating shocks to the nominal exchange rate, which have been found to be very significant in many countries with flexible exchange rates. Second, monetary union may reduce trading costs and induce stronger trade linkages between the new member country and existing members. The source of macroeconomic costs are well known as the new member country must give up an independent monetary policy where the nominal exchange rate can potentially act as shock absorber. The paper also assesses how this assessment of the costs and benefits depend on the degree of nominal and real rigitities.