Welfare Reversal in Monetary Union

We show that the welfare costs of business cycles in a monetary union can be higher under incomplete financial markets than under complete markets. A monetary union with home bias, sticky prices and country-specific shocks is a second-best environment in which the structure of financial markets shapes the extent of risk-sharing but also the welfare costs of nominal rigidities. If the Marshall-Lerner condition is met, complete financial markets increase the volatility of terms of trade, and that of inflation rates. The corresponding increase in welfare losses from nominal rigidities can overturn the welfare gains from a better sharing of risks.