In this paper, we consider the effect of a monetary union in a model with a significant role for financial market imperfections. We do so by introducing a financial accelerator into a stochastic general equilibrium macro model of a two country economy. We show that financial market imperfections introduce important cross-country transmission mechanisms to asymmetric shocks to supply and demand. Within this framework, we study the likely costs and benefits of monetary union. We also consider the effects of cross-country heterogeneity in financial markets. Both the presence of financial frictions and the use of a single currency have significant impacts on the international propagation of exogenous shocks. The introduction of asymmetries in the financial contract widens the difference in cyclical behavior of national economies in a monetary union, but financial integration compensates the loss of policy instruments.
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Last update: August 21, 2002