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OPTIMAL MONETARY AND FISCAL POLICY IN A CURRENCY UNION WITH FRICTIONAL GOODS MARKETS

Published online by Cambridge University Press:  04 November 2019

Pedro Gomis-Porqueras  and
Cathy Zhang
Pedro Gomis-Porqueras
Affiliation:
Deakin University
Cathy Zhang*
Affiliation:
Purdue University
*
Address correspondence to: Cathy Zhang, Department of Economics, Krannert School of Management, Purdue University, 100 South Grant Street, West Lafayette, IN 47907, USA. e-mail: cmzhang@purdue.edu.
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Abstract

We develop an open economy model of a currency union with frictional goods markets and endogenous search decisions to study optimal monetary and fiscal policy. Households finance consumption with a common currency and can search for locally produced goods across regions that differ in their market characteristics. Equilibrium is generically inefficient due to regional spillovers from endogenous search decisions. While monetary policy alone cannot correct this distortion, fiscal policy can help improve allocations by taxing or subsidizing production at the regional level. When households of only one region can search, optimal policy entails a deviation from the Friedman rule and a production subsidy (tax) if there is underinvestment (overinvestment) in search decisions. Optimal policy when households from both region search requires the Friedman rule and zero production taxes in both regions.

Keywords

Currency UnionsSearch FrictionsOptimal Monetary and Fiscal Policy
Type
Articles
Information
Macroeconomic Dynamics , Volume 25 , Issue 7 , October 2021 , pp. 1726 - 1754
Copyright
© Cambridge University Press 2019

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Footnotes

We thank the Associate Editor and two anonymous referees for their comments and advice. Jacklyn Buhrmann, Benjamin Raymond, and Wumian Ashley Zhao provided excellent research assistance. The authors declare no relevant or material financial interests that relate to the research described in this paper.

References

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