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This paper investigates how monetary policy should be conducted in a two-region general equilibrium model with monopolistic competition and price stickiness. This framework delivers a simple welfare criterion based on the utility of the consumers that can be used to evaluate monetary policy in a currency area. If the two regions share the same degree of nominal rigidity, the terms of trade are completely insulated from monetary policy and the optimal outcome is obtained by targeting a weighted average of the regional inflation rates. These weights coincide with the economic sizes of the region. If the degrees of rigidity are different, the optimal plan implies a high degree of inertia in the inflation rate. But an inflation targeting policy in which higher weight is given to the inflation in the region with higher degree of nominal rigidity is nearly optimal.

“What is the appropriate domain of a currency area? It might seem at first that the question is purely academic since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement”1 With the creation of the European Central Bank, what seemed to be a pure academic speculation has become a reality. Following Mundell’s seminal work, several contributions have emphasized the conditions under which a currency area is optimal. However, the monetary aspects of a currency area have been neglected mainly because, as suggested by the above quotation, the abandonment of national currencies was considered politically infeasible. The primary purpose of this paper is to investigate the optimal conduct of monetary policy in a currency area characterized by asymmetric shocks across regions. Whether monetary policy should stabilize an aggregate measure of inflation or output or whether it should take into account the dispersion of inflation or output across regions is an unsolved question. This issue has received an increasing interest in the current policy debate on the conduct of monetary policy within the Euro area.2 This paper contributes to the debate in two ways: first, a stylized model that helps to understand how currency areas work and second, a micro-founded welfare criterion that allows normative analysis.3 Our main conclusion is that monetary policy should follow a particular inflation targeting policy in which higher weight is given to the inflation rate in the region with higher degree of nominal rigidity. This work presents a two-region model, where each region is specialized in the production of a bundle of differentiated goods and where labor is immobile across regions.4 Money is not neutral because there are rigidities in prices. Monopolistic competition rationalizes the existence of price stickiness. A two-region model represents the minimum requirement in order to study the important role of relative prices. When different regions experience asymmetric shocks, movements in the terms of trade are important in explaining the transmission mechanism of monetary policy. The normative results are rooted in the analysis of the existing distortions. In our framework there are three sources of inefficiency: (i) the monopolistic distortion that induces an inefficient level of output; (ii) inflation in each region that creates an inefficient dispersion of prices; and (iii) price stickiness that may create a non-efficient path of the terms of trade in response to asymmetric disturbances. By using a deadweight loss evaluation, as in monetary models by Rotemberg and Woodford (1997) and King and Wolman (1998), it is possible to build a welfare criterion that accounts for the exact magnitude of these distortions. In this context the optimal policy is the one that provides the most efficient allocation of resources. Abstracting from the inefficiencies induced by monopolistic competition, monetary policy makers would be expected to stabilize prices within each region, thus avoiding the dispersion of output across resources produced using the same technology, and would be expected to induce the right changes in relative prices across regions, thus allocating resources efficiently following asymmetric shocks. However, this combined outcome is not feasible. The optimal plan implies a high degree of inertia in the inflation rates. This feasible first-best can be approximated by an inflation targeting policy in which higher weight is given to the inflation in the region with higher degree of nominal rigidity. This principle is natural, given that the regions with stickier prices create more distortions in the whole area. The idea that monetary policy should help in creating an environment in which resources are allocated efficiently is well grounded in the monetary policy agenda. The Bulletin of January 1999, ECB (1999), explicitly states that one of the main arguments for price stability is that “price stability improves the transparency of the relative price mechanism thereby avoiding distortions and helping to ensure that the market will allocate real resources efficiently both across uses and across times. A more efficient allocation will raise the productive potential of the economy.” As it happens, the architects of the European Monetary Union have specified a quantitative target in terms of a weighted average of the harmonized index of consumer prices of the countries belonging to the union (HICP-targeting): the weights coincide with each country’s share of total consumption. In this work, we show that the HICP-targeting is optimal only when the regions share the same degree of nominal rigidity. For example, consider two regions of equal GDP size such as France and Germany. HICP-targeting implies that each country has a weight equal to one half. Instead, if price contracts in Germany last 20% longer than in France, then the weight given to German inflation rate should be increased by 20%. Moreover, the deadweight losses can be substantially reduced by shifting from the HICP-targeting to our proposed policy even for a small difference in the degree of nominal rigidity across regions. We find that the gains from pursuing an optimal policy can be as large as the cost of losing the exchange rate as an instrument. We evaluate them around 0.02% of a permanent shift in steady-state consumption. In a currency area characterized by labor immobility, relative price stickiness, and decentralized fiscal policy, the impossibility of achieving the efficient outcome is similar to the Mundellian theory on the optimum area except with a new micro-founded perspective. Indeed, the interpretation instrument-toward-distortions emphasizes the lack of instruments. In Benigno (2001), it is shown that the exchange rate provides the flexibility needed in order to achieve the efficient outcome. The work is organized as follows. Section 1 presents the structure of the model. In Section 2, the log-linear approximation to the equilibrium conditions is presented. Section 3 offers the welfare analysis and determines the optimal policy. Section 4 compares the outcomes of a certain class of policies. Finally, Section 5 outlines some possible extensions in this research program.

In this work we have analyzed a currency union in a stochastic general equilibrium model. Our simple framework has provided interesting insights on the transmission mechanism within a currency area. By using the ‘taxation approach’, we have been able to evaluate the exact magnitude of the distortions existing in our model. A welfare criterion has been retrieved in terms of the inflation rates, the output gap and relative prices. According to this measure, we have shown that the optimal plan implies a high degree of inertia in the inflation rate. However, a particular inflation targeting policy can well approximate the feasible first-best. In this inflation targeting policy higher weight should be given to the region with higher degree of nominal rigidity. In the companion Appendix the extension to a K-region economy is presented. The main results still hold. In this direction our model proposes further insights into the debate on the various measures of core inflation, see Bryan and Cecchetti (1994). A general equilibrium approach to core inflation has been introduced by Aoki (2001). In this context it is natural to define core inflation as the inflation rate that monetary policy should stabilize in order to maximize the welfare. Our prescription is then that monetary policy should stabilize a weighted average of the sectorial inflation rates, but with higher weight to be given to the sector with higher degree of nominal rigidity. This is consistent with the idea of Bryan and Cecchetti (1994) that core inflation should be inferred from the expectations-based price setters. However, even changes in prices, smaller than the average, should be excluded from the relevant inflation index, if associated with sector characterized by low degree of nominal rigidity. However, there are other directions in which the main policy prescription of this paper is not robust. In the presence of other sources of rigidity, e.g. wage stickiness as in Erceg et al. (2000), monetary policy should take in consideration wage inflation in formulating its optimal policy. Instead if the monopolistic distortions are time varying, it is the case that monetary policy should target an appropriate output gap as well as inflation. Moreover, if the liquidity services from holding money are not marginal, monetary policy should also pay attention to the volatility of the nominal interest rate. This is also the case if the zero-floor bound on the nominal interest rate is embedded in the analysis, as in Woodford, 1999 and Woodford, 2002. These qualifications affects our final conclusions but not our emphasis on the distortions that arise because relative prices are sticky. In a more general setting monetary policy should balance the latter distortions with others in order to formulate the optimal policy. Finally, this paper has only focused on the optimal path of the economy without analyzing how this optimal plan can be implemented. Further research on how monetary policy should use all it information in order to implement the optimal policy has to be conducted.