Taking Real Rigidities Seriously: Implications for Optimal Policy Design in a Currency Union

Abstract In this paper I analyze optimal monetary and fiscal policy in a monetary union from a union-wide perspective. For this purpose I lay out a New Keynesian business cycle model of a currency union with rigid real wages. The fiscal policy is implemented at the country level through the choice of government spending, while the monetary authority sets a common nominal interest rate. I find that, given these assumptions, in the presence of country-specific as well as in the presence of symmetric shocks to technology there is a country-level trade-off between stabilizing inflation and output relative to its efficient outcome. After a union-wide technology shock also the common monetary authority faces a trade-off. Hence, if the shift to technology is common to all member countries the optimal policy on a union-wide level requires that the common monetary policy reacts slightly countercyclical. This is reversed on the domestic level, where, under the optimal policy, the government purchases stabilize the economy via countercyclical spending, no matter if shocks are symmetric or not. Although not always optimal, I find that strict inflation targeting is very close to the optimal policy in terms of aggregate welfare losses