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Deciding to Enter a Monetary Union: TheRole of Trade and Financial Linkages

Author/Editor: Lama, Ruy | Rabanal, Pau
Authorized for Distribution: October 2, 2012
Electronic Access: Free Full Text (PDF file size is 1,521KB)
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Summary: 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, and use the model to compute the welfare trade-offs from joining the euro. We evaluate two alternative scenarios. In the first one, we consider a reduction of trade costs that occurs after the adoption of a common currency. In the second, we introduce interest rate spread shocks of the same magnitude as the ones observed during the recent debt crisis in Europe. The reduction of trade costs generates a net welfare gain of 0.9 percent of life-time consumption, while the increased interest rate spread volatility generates a net welfare cost of 2.9 percentage points. The welfare calculation suggests two ways to preserve the welfare gains in a monetary union: ensuring fiscal and financial stability that reduces macroeconomic country risk, and increasing wage flexibility such that the economy adjusts to external shocks faster.
 
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Series: Working Paper No. 12/240
Subject(s): Monetary unions | United Kingdom | European Economic and Monetary Union | Euro Area | Economic integration | Trade integration | Economic models
 
English  
    Published:   October 2, 2012        
    ISBN/ISSN:   9781475511437/2227-8885   Format:   Paper
    Stock No:   WPIEA2012240   Pages:   53
    Price:   US$18.00
       
     
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