Small Open Economy Model with Domestic Resource Shocks: Monetary Union vs. Floating Exchange Rate

This paper developes a small open economy model in which domestic resource shocks play a vital role in driving the dynamics of the major macroeconomic aggregates. Households rent capital and labour to firms and have access to an international bond market. The model is calibrated to recent Icelandic data and simulated under two alternative exchange rate regimes: floating rates, and monetary union membership. It is found that by entering a larger currency area, the volatility of the real exchange rate, real wages and consumption are sharply reduced, but output and employment are seen to be more volatile. Smoother consumption renders monetary union marginally Pareto superior to floating. Under monetary union and low inflation, slight nominal wage reductions may be required at times to absorb adverse resource shocks.