Real and Monetary Disturbances in an Exchange—Rate Union

This paper investigates how a small country fares in an exchange— rate union if that country is subject to real and monetary disturbances originating at home and abroad. By joining a union, the country can fix the exchange rate between its currency and the currency of another country or countries. The paper asks whether or not fixing this exchange rate helps to modify the effects of disturbances on the domestic economy. This question is investigated within a model consisting of an aggre-gate demand equation dependent upon the terms of trade, an aggregate supply equation in which labor supply is responsive to the general price level, and a financial equation that determines the exchange rate of the domestic currency relative to one of two foreign currencies (the other being determined by triangular arbitrage). Aggregate supply behavior varies depending upon whether wages respond to prices with a lag or are indexed to current changes in the general price level. Because the small country model cannot b