Large Union and Rest of the World

So far we considered a small monetary union. Now, instead, we shall consider a large monetary union. Properly speaking, the world economy consists of two regions, the monetary union and the rest of the world. We assume perfect capital mobility between the union and the rest of the world. Therefore the union interest rate agrees with the interest rate in the rest of the world r₁ = r₂. It is worth emphasizing that here the world interest rate r becomes endogenous. The exchange rate between the union and the rest of the world is floating. The union produces good 1, while the rest of the world produces good 2. P₁ denotes the price of good 1, and P₂ is the price of good 2. Without loss of generality, we postulate P₁ = P₂ = 1. e is the exchange rate of the union (e.g. the price of the dollar in terms of the euro). The initial value is set at e = 1.