Regional Economic and Monetary Integration: A Modelling and Policy Analysis

This paper is concerned with developing a simple two-country model with the objective of identifying the macroeconomic impact arising for a small open economy from shocks emanating from a large country. The latter can also be interpreted as representing a bloc of countries that exert an important influence upon the small country. The approach adopted is to conduct some simple simulations focusing upon external shocks emanating from the large country and its economic impact upon the small country, identifying in the process under what circumstances a policy response by the small country would be optimal in the sense of reducing the volatility of key macroeconomic variables such as the domestic price level, the exchange rate, the domestic interest rate and domestic output. In doing so, this analysis can enable identification of the desirability, or otherwise, of a coordination of macroeconomic policy between the large and small country, and under what circumstances it would be desirable to conduct an autonomous macroeconomic policy. The analysis is conducted by means of generating a calibrated solution and simulation of the model.