Small Union of Two Countries

Consider a regional economy that is made up of two subregions, the monetary union and the group of associated countries. The monetary union on its part is composed of two countries. Index 1 stands for union country 1, 2 for union country 2, 3 for the group of associated countries, and 4 for the rest of the world. The exchange rate between the union and the associated countries is fixed. The exchange rate between the union and the rest of the world is flexible. And the same applies to the exchange rate between the associated countries and the rest of the world. Figure 1 visualizes the approach.