Monetary stabilisation in a currency union: The role of catching up member states

We examine the conduct of monetary policy in the face of aggregate and sectoral productivity shocks. The stabilisation performance of a currency union depends on the distribution of shocks across the union, as well as on key parameter values. The currency union tends to deliver a better outcome than autonomous monetary policy when countries are hit by aggregate supply shocks. This is especially the case when member states are rather homogeneous in terms of size and output-inflation tradeoffs, and when they share a strong preference for price stability. In contrast, sectoral productivity shocks giving rise to Balassa-Samuelson-type pressures on real exchange rates hamper monetary union's stabilisation properties, making autonomous monetary policy a preferable alternative.