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Small Open Economy Model With Domestic Resource Shocks: Monetary Union Vs. Floating Exchange Rate

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  • Tor Einarsson

Abstract

This paper developes a small open economy model in which domestic resource shocks play a vital role in driving the dynamics of the major macroeconomic aggregates. House- holds rent capital and labour to rms and have access to an international bond market. The model is calibrated to recent Icelandic data and simulated under two alternative exchange rate regimes: oating rates, and monetary union membership. It is found that by entering a larger currency area, the volatility of the real exchange rate, real wages and consumption are sharply reduced, but output and employment are seen to be more volatile. Smoother consumption renders monetary union marginally Pareto superior to oating. Under mon- etary union and low ination, slight nominal wage reductions may be required at times to absorb adverse resource shocks. [JEL Codes: E32, E42, F31, F41. Key words: domestic resource shocks, exchange rate regime, stabilization, welfare costs.]

Suggested Citation

  • Tor Einarsson, 2002. "Small Open Economy Model With Domestic Resource Shocks: Monetary Union Vs. Floating Exchange Rate," Economics wp18_tor, Department of Economics, Central bank of Iceland.
    • Handle: RePEc:ice:wpaper:wp18_tor
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    Keywords

    domestic resource shocks; exchange rate regime; stabilization; welfare costs.];
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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