and product markets. In this respect, adjustment can be achieved through movements in
the relative prices and wages.
Compared to the case of national monetary policy (NMP), EMU should impose less
discipline on wage setters for they perceive an increase in their wages to have a smaller
impact on the union-wide inflation rate relative to the one on their country-specific in-
flation rate. This point has been recently stressed in literature on strategic wage setting
(e.g. Coricelli et al., 2004; Cukierman and Lippi, 2001; Soskice and Iversen, 1998; Grfiner
and Hefeker, 1999).
However when countries trade with each other new issues arise from the strategic
interactions among the Home and Foreign central bank (CB) and Home and Foreign
labor unions. Cuciniello (2007) argues that, under a NMP regime, the optimal monetary
policies in the two countries are strategic complements and are influenced by the labor
market adjustments. This paper aims to extend the setup by Lippi (2003) to an open
economy with monopolistic competitive firms so as to contribute with a study on the long
run macroeconomic consequences of a monetary regime shift from floating exchange rates
to a monetary union (MU).
We use a general-equilibrium model of two countries, different in size and labor market
institutions, characterized by monopolistic competition in the product market and union-
ized labor markets. In a micro-founded framework in line with the new open economy
macroeconomics, we show that, aside from the response of real wages to labor market con-
ditions, the move to a MU raises inflation since it increases the common CB’s temptation
to resort to surprise inflation relative to national CBs. Moreover we demonstrate that
welfare and employment are unambiguously higher in a MU when monopoly distortions
in the labor market are not so relevant. By contrast, when labor market distortions are
sizeable the results may be ambiguous. In particular if the CB conservatism (CBC) is low,
there exists a level of Foreign CBC that renders welfare and employment higher under a
NMP regime, while for high levels of monetary conservatism employment and welfare are
maximized in a MU.
The structure of the paper is as follows. Section 2 develops the model in a MU regime.
Section 3-6 compute the optimal strategy of each player. Section 7 analyzes the effects of
the number of unions and CBC on employment and inflation in the two regimes. Section
8 presents the conclusions.
2 Economic Setup
The monetary union is formed by two countries, Home (H) and Foreign (F). The world
size is normalized to 1; Home agents are indexed by numbers in the interval [O,7], while
Foreign agents reside on (7, 1], where 7 ∈ (0,1) is a measure of relative population and
economic size.
There are two types of goods in the MU, and each country specializes in the production