Monetary and Labor Interactions in a Monetary Union

A two-country general equilibrium model with large wage setters is developed to investigate the welfare implications of moving from a flexible exchange rate regime to a monetary union. The paper shows that the currency regime not only affects the central bank's incentive to improve the terms of trade but also the labor unions', generating different strategic interactions between monetary policy and wage setting. A switch from non-cooperation to monetary union does not necessarily lead to wage increases. However, a common central bank can be beneficial when a country is sufficiently open to trade, since the expected welfare gain due to the strategic effects at work more than offsets the welfare loss resulting from monetary policy's inability to optimally stabilize the effects of asymmetric shocks.