MONETARY POLICY IN A CURRENCY UNION WITH HETEROGENEOUS COUNTRIES

We build a two-country DSGE model for a currency union, with habit formation, product and labour differentiation and nominal rigidities. Monetary policy is defined by a rule that responds to the area’s macro-variables averages weighted by each country's size. We intend to study the impact of different sources of heterogeneity between the countries (home bias in consumer preferences, wage and price mark-ups and wage and price setting rigidity) on both countries and the union. The model is calibrated and the response to shocks is simulated. The main innovation is the incorporation of several sources of heterogeneity and the assessment of its impact on welfare. The main results of the model simulation are the following: (i) only heterogeneity regarding the home bias can lead to differentials in consumer price inflation; (ii) heterogeneity regarding wage or price mark-ups does not lead to significantly different responses to shocks of the countries; (iii) heterogeneity on nominal rigidities results in differences among the countries ’ response, favouring the more flexible country and resulting in smoother and longer impacts when shocks occur in the more rigid country