The effects of the terms of trade on monetary policy

<ns3:p>Background The design of monetary policy in a currency union poses challenges that differ fundamentally from those in stand-alone economies. When fiscal authority remains decentralized, asymmetric developments in prices, output, or competitiveness can lead to persistent welfare losses. The euro area (EA), governed by a single monetary policy but lacking centralized fiscal capacity, provides a revealing laboratory to study these tensions. This paper examines how intra-union heterogeneity, measured through terms-of-trade dispersion, influences the conduct and effectiveness of monetary policy in a two-country New Keynesian (NK) framework. Methods The analysis develops a stylized two-country NK model calibrated to reflect the institutional structure of the EA, with the central bank reacting to the union-wide inflation rate. The model highlights the role of country-level stabilization capacity in ensuring equilibrium uniqueness under common monetary policy. Empirically, the paper constructs novel indicators of internal terms-of-trade dispersion for both the EA and the United States, using GDP deflators and weighted GDP measures. Bayesian estimation techniques are employed to identify Taylor-rule parameters, including the sensitivity of policy rates to domestic heterogeneity. Results The findings indicate that terms-of-trade dispersion has become a significant driver of monetary policy asymmetries in the EA, while remaining negligible in the US. The estimated policy response to inflation is lower in the EA than in the US, and the welfare losses associated with heterogeneous price dynamics are amplified when fiscal coordination is weak. Conclusions The results suggest that achieving macroeconomic stability in the EA requires greater fiscal coordination and an operational definition of price stability that internalizes intra-union heterogeneity. The analysis underscores the importance of complementing monetary integration with fiscal instruments capable of offsetting region-specific shocks, aligning the EA’s institutional framework more closely with that of mature monetary unions.</ns3:p>