This paper evaluates the welfare gains arising from deeper trade integration in the European Monetary Union. To do this, the European Monetary Union is represented in a realistic way by an intertemporal general equilibrium model with incomplete financial markets, sticky prices, and home bias in production. The model is estimated and not rejected by the data. Two main results emerge: (i) an increase in vertical trade (occuring at the early stage of the production process) implies welfare gains whereas (ii) an increase in horizontal trade (occuring at the late stage of the production process) implies welfare losses.

We build a model of trade and location with two countries which differ with respect to their level of productivity. Public spending has two possible allocations: a direct subsidy to immobile households or a wage subsidy to mobile firms. We show that firms receive a lower net of tax subsidy in the high-productivity country than in the low-productivity one. Despite this less generous policy, the former country can host a larger share of firms, so that its total spending for firms can be higher than in the low-productivity country when trade costs are low enough. The welfare analysis suggests that the second-best optimum requires an increase in the subsidy to households in both countries when the economies are weakly integrated or the productivity gap is low or the share of capital incomes redistributed outside the two economies is high.