Designing Stabilization Policy in a Monetary Union

While the European Monetary Union (EMU) is now a reality, debate among economists nonetheless continues about the design and desirability of monetary unions. Since an essential element of a monetary union is the delegation of monetary power to a single centralized entity, one of the key issues in this debate is whether a monetary union will limit the effectiveness of stabilization policy. If so, monetary union will not necessarily be welfare improving. In this paper, we study a two-country world economy and consider various designs of monetary union. We argue that the success of monetary union depends on: (i) the commitment ability of the single central bank, (ii) the policy flexibility of the national fiscal authorities and the central monetary authority and (iii) the cross country correlation of shocks. If, for example, the central bank moves before the fiscal authorities, then a monetary union will increase welfare as long as fiscal policy is sufficiently responsive to shocks. However, if the fiscal authorities have a restricted set of tools and/or the monetary authority lacks the ability to commit to its policy, then monetary union may not be desirable.