Should Small Countries Join an Existing Monetary Union ?

Abstract

We explore the welfare consequences of the alternative monetary and exchangerate regimes still available to the small country in open international financial markets in view of the optimum monetary policy that the large country adopts for itself. Both economies are based on nominal wage contracts with employment determined by the demand for labor under the contract terms. Reacting to movement in contemporaneously observable price variables, the monetary authorities of the large country, and of the small country under floating, aim to keep labor on its supply curve in the face of IS and LM shocks to aggregate demand, and shocks to aggregate supply. With monetary union, the small country trades discretionary monetary policy for greater stability in real exchange rates and insulation from its own idiosyncratic money supply and demand disturbances. The relative welfare costs of the different regimes for the small country are modeled and deduced from researched parameter values. The result is that there can be a stabilization rationale for accession to a monetary union except at low values of the correlations of like types of shocks for the large and small country.