On Financial Markets Incompleteness, Price Stickiness, and Welfare in a Monetary Union

The paper builds a two-country model of a monetary union with home bias and price stickiness. Incompleteness of financial asset markets is allowed. In this environment, we derive the solution for optimal behavior by the monetary policymaker and show that welfare can be higher under incomplete markets than under complete markets. The argument is a second-best one. In a monetary union with equal nominal rigidity across countries, optimal monetary policy stabilizes aggregate, union-wide inflation, but cannot fully stabilize the country-level inflation rates. Market incompleteness results in less volatility of the terms-of-trade (because part of the adjustment goes through the current account), and hence less volatile national inflation rates. Through this channel, welfare ends up being higher under incomplete markets. These results are also robust when nominal rigidity differs across countries and whenthe form of the monetary policy is modified.