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This paper evaluates the role of trade and financial linkages in the decision to enter a monetary union. We estimate a two-country DSGE model for the U.K. economy and the euro area, and use the model to compute the welfare trade-offs from joining the euro. We evaluate two alternative scenarios. In the first one, we consider a reduction of trade costs that occurs after the adoption of a common currency. In the second, we introduce interest rate spread shocks of the same magnitude as the ones observed during the recent debt crisis in Europe. The reduction of trade costs generates a net welfare gain of 0.9 percent of life-time consumption, while the increased interest rate spread volatility generates a net welfare cost of 2.9 percentage points. The welfare calculation suggests two ways to preserve the welfare gains in a monetary union: ensuring fiscal and financial stability that reduces macroeconomic country risk, and increasing wage flexibility such that the economy adjusts to external shocks faster.

Finance --- Business & Economics --- International Finance --- Monetary unions. --- International trade. --- External trade --- Foreign commerce --- Foreign trade --- Global commerce --- Global trade --- Trade, International --- World trade --- Common currencies --- Currency areas --- Currency unions --- Optimum currency areas --- Commerce --- International economic relations --- Non-traded goods --- Currency question --- Money --- Monetary unions --- Eurozone --- Econometric models --- Economic and Monetary Union. --- E-books --- Euro area --- Euro zone --- EMU --- WWU --- Europäische Wirtschafts- und Währungsunion --- Unión Económica y Monetaria Europea --- Oikonomikē kai Nomismatikē Henōsē --- ONE --- European Monetary Union --- Talous- ja rahaliitto --- Unione monetaria --- Euroopan talous- ja rahaliitto --- Rahaliitto --- European Economic and Monetary Union --- UME --- Unione monetaria europea --- EWWU --- Unión Monetaria Europea --- Ekonomiska och monetära unionen --- Union monétaire européenne --- Union économique et monétaire européenne --- UEM --- Unia Gospodarcza i Walutowa --- Banks and Banking --- Exports and Imports --- Financial Risk Management --- Foreign Exchange --- Macroeconomics --- Money and Monetary Policy --- Monetary Policy --- Open Economy Macroeconomics --- International Policy Coordination and Transmission --- International Business Cycles --- Financial Aspects of Economic Integration --- Macroeconomics: Consumption --- Saving --- Wealth --- Interest Rates: Determination, Term Structure, and Effects --- Financial Crises --- Monetary Systems --- Standards --- Regimes --- Government and the Monetary System --- Payment Systems --- International economics --- Currency --- Foreign exchange --- Economic & financial crises & disasters --- Monetary economics --- Consumption --- Interest rate parity --- Real exchange rates --- Financial crises --- Economic integration --- National accounts --- Financial services --- Currencies --- Economics --- Interest rates --- United Kingdom

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We study the optimal management of capital flows in a small open economy model with financial frictions and multiple policy instruments. The paper reports two main findings. First, both foreign exchange intervention (FXI) and macroprudential polices are tools complementary to the monetary policy rate that can largely reduce inflation and output volatility in a scenario of capital outflows. Second, the optimal policy mix depends on the underlying shock driving capital flows. FXI takes the leading role in response to foreign interest rate shocks, while macroprudential policy becomes the prominent tool for domestic risk shocks. These results highlight the importance of calibrating the use of multiple instruments according to the underlying shocks that induce shifts in capital flows.

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We study the optimal foreign exchange (FX) intervention policy in response to a positive terms of trade shock and associated Dutch disease episode in a small open economy model. We find that during a Dutch disease episode tradable production drops below the socially optimal level, resulting in lower welfare under learningby- doing (LBD) externalities. FX reserves accumulation improves welfare by preventing a large appreciation of the real exchange rate and by inducing an efficient reallocation between the tradable and non-tradable sectors. For an empirically plausible parametrization of LBD externalities, the model predicts that in response to a 10 percent increase in commodity prices FX reserves should increase by 1.5 percent of GDP. We also find that the welfare gains from optimally using FX reserves are twice as high as the gains from relying only on monetary policy. These results suggest that FX intervention is a beneficial policy to counteract the loss of competitiveness during a Dutch disease episode.

Foreign exchange rates. --- Foreign exchange rates --- Monetary policy --- International finance --- International monetary system --- International money --- Finance --- International economic relations --- Exchange rates --- Fixed exchange rates --- Flexible exchange rates --- Floating exchange rates --- Fluctuating exchange rates --- Foreign exchange --- Rates of exchange --- Econometric models. --- Rates --- Investments: Energy --- Foreign Exchange --- Macroeconomics --- Economic Theory --- Commodity Markets --- Resource Booms --- Central Banks and Their Policies --- Open Economy Macroeconomics --- Currency --- Economic theory & philosophy --- Investment & securities --- Commodity prices --- Dutch disease --- Commodity booms --- Prices --- Economic theory --- Commodities --- Economic forecasting --- Commercial products --- Brazil

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We build a small open economy, real business cycle model with labor market frictions to evaluate the role of employment protection in shaping business cycles in emerging economies. The model features matching frictions and an endogenous selection effect by which inefficient jobs are destroyed in recessions. In a quantitative version of the model calibrated to the Mexican economy we find that reducing separation costs to a level consistent with developed economies would reduce output volatility by 15 percent. We also use the model to analyze the Mexican crisis episode of 2008 and conclude that an economy with lower separation costs would have experienced a smaller drop in output and in measured total factor productivity with no significant change in aggregate employment.

Job security --- Labor market --- Business cycles --- Economic cycles --- Economic fluctuations --- Cycles --- Employees --- Market, Labor --- Supply and demand for labor --- Markets --- Employment protection --- Employment security --- Job insecurity --- Security, Job --- Economic security --- Personnel management --- Layoff systems --- Econometric models. --- Supply and demand --- Labor --- Macroeconomics --- Production and Operations Management --- Employment --- Unemployment --- Wages --- Intergenerational Income Distribution --- Aggregate Human Capital --- Aggregate Labor Productivity --- Business Fluctuations --- International Business Cycles --- Unemployment Insurance --- Severance Pay --- Plant Closings --- Labor Economics: General --- Production --- Cost --- Capital and Total Factor Productivity --- Capacity --- Macroeconomics: Production --- Prices, Business Fluctuations, and Cycles: General (includes Measurement and Data) --- Labour --- income economics --- Economic growth --- Total factor productivity --- Productivity --- Industrial productivity --- Labor economics --- Economic theory --- Mexico

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We study exchange rate dynamics under cooperative and self-oriented policies in a two-country DSGE model with unconventional monetary and exchange rate policies. The cooperative solution features a large exchange rate adjustment that cushions the impact of negative shocks and a moderate use of unconventional policy instruments. Self-oriented policies (Nash equilibrium), however, entail limited exchange rate movements and an aggressive use of unconventional policies in both countries. Our results highlight the role of international policy cooperation in allowing the exchange rate to play the traditional role of shock absorber.

Foreign Exchange --- Investments: Bonds --- Money and Monetary Policy --- Monetary Policy --- Open Economy Macroeconomics --- International Policy Coordination and Transmission --- International Business Cycles --- General Financial Markets: General (includes Measurement and Data) --- Currency --- Foreign exchange --- Investment & securities --- Monetary economics --- Real exchange rates --- Bonds --- Unconventional monetary policies --- Exchange rates --- Financial institutions --- Monetary policy --- United States