Deciding to enter a monetary union: The role of trade and financial linkages

Abstract

This paper evaluates the role of trade and financial linkages in the decision to enter a monetary union. We estimate a two-country DSGE model for the U.K. economy and the euro area with financial intermediaries as in Gertler and Karadi (2011). We use the model to compute the welfare trade-offs from joining the euro. We compare the gains from trade that would occur after the adoption of the euro against the costs of relinquishing monetary policy, both conventional and unconventional. We also study the effects of the changes in the corporate risk premium observed during the recent crisis. We find that in tranquil times, when the risk premium volatility is low, the net welfare gain of joining the monetary union is 2.4 percent of life-time consumption. During financial crises, when there is a sharp increase in the volatility of the risk premium, joining a monetary union would lead to a net welfare loss of 2.2 percent of life-time consumption. The welfare analysis underscores the importance of financial stability to sustain a monetary union over time.