Welfare Effects of a Monetary Union: The Role of Trade Openness

This paper evaluates the welfare effects of a monetary union (MU), compared to a floating exchange rate regime, using a quantitative business cycle model of a two-country world with sticky prices. It is assumed that, under a float, there are shocks to the uncovered interest rate parity (UIP) condition. These shocks are shown to have a negative effect on welfare-the detrimental effect is stronger, the higher the degree of trade openness. A MU eliminates UIP shocks, and it may thus raise welfare. The welfare gain from MU is positively linked to openness. (JEL: E4, F3, F4) Copyright (c) 2004 The European Economic Association.