Models of two big economies and a monetary union

Abstract

The analysis of open economy in a short term both in the theory of economics
and education has a very strong foundation in the IS-LM-BP Model,
which has limitations that have a fundamental practical importance in the
context of the European integration. Namely, the model does not allow for
a monetary union case study. Because of that, it is worth looking closely at
the analysis of the domestic and foreign economy, which is possible within the
model of the two economies. Broadening the perspective onto two entities
allows not only for observation of the effects of macroeconomic shocks in
the two economies but also for a detailed analysis of mechanisms responsible
for the transmission of shocks from one country to another. In addition, the
approach based on two economies let the author develop a completely new
model of two countries functioning in the conditions of a monetary union,
which allows for an analysis of shock transmission that is not possible in case
of a model with a fixed currency exchange rate. The presented model of two
economies functioning in the conditions of a monetary union also has educational
advantages connected with its simplicity in comparison with a model
of two big economies. The analysis of the models of two big economies with
flexible currency exchange rate and economies in a monetary union shows
considerable differences in the functioning of the two group types. The differences
concern not only the effects of macroeconomic shocks (both real and
nominal) in the analysed countries but also the way of transmitting shocks
from one country to another.