When do Countries Benefit from Forming a Monetary Union?

The New Keynesian DSGE literature has come to the consensus that, from the perspective of business cycle stabilization, countries are worse off in terms of welfare by forming a monetary union. This consensus, however, is based on the assumption of monetary policy being optimal. Using a standard two-country model, this paper shows that under suboptimal monetary policy, countries may gain in welfare by forming a monetary union, highlighting an important inherent benefit of fixing the exchange rate. Whether countries benefit from a monetary union depends primarily on the degree of price stickiness and how monetary policy is conducted: If prices are rather sticky and if monetary policy is not very aggressive towards inflation, forming a monetary union is beneficial. In contrast, asymmetries in the degree of price stickiness between countries are not of any importance for a monetary union to be welfare-enhancing or not.