Monetary Policy, Currency Unions and Open Economy Macrodynamics

In this paper we extend an integrated closed-economy macrodynamic model to account for a large open economy in a currency area with fixed nominal exchange rates between the currencies. The major issues are the effectiveness and macrodynamic effects of monetary policy for countries in a pegged or fixed exchange rate system. The model assumes a leader-follower relationship as in Kenen (2002) where the dominant country pursues a monetary policy and the other countries adjust. We explore the effect of two policy rules - the monetary authority targeting the money supply or interest rate. The model augments Keynesian AS-AD growth dynamics by goods  market disequilibrium, price and quantity adjustment processes and income distribution dynamics and is completely specified with respect budget and behavioral equations. The steady state of the resulting 7D dynamical system is asymptotically stable for sluggish responses to labor and goods market imbalances, if the Keynes-effect is strong and sales expectations sufficiently fast. Increasing adjustment speeds for wages, prices, inflationary expectations or inventories however implies loss of local stability by way of Hopf-bifurcations. Monetary policy rules augment the dimension of the considered dynamics by one (interest rate rule) or two (money supply rule) and may stabilize the economy to some extent if the adjustment speeds in these rules are chosen with care. Yet, behavioral nonlinearities are needed in addition to ensure economic viability over a larger range of the parameter values of the model.