Optimal monetary and fiscal policy in a currency union with nontradables

By constructing a dynamic stochastic general equilibrium (DSGE) model, this paper verifies the necessity for an optimal monetary and fiscal policy under a currency union with non-tradable goods. An optimal monetary policy alone can maximize social welfare through stabilizing the producer price inflation and output gap in each country simultaneously when all goods are tradable. However, a solitary optimal monetary policy cannot maximize social welfare because of the Balassa-Samuelson Theorem when non-tradable goods exist. In this case, a cooperative optimal monetary and fiscal policy maximizes social welfare. Also, self-oriented fiscal authority can replicate optimal allocation similar to a cooperative setting.