PRODUCTION SHARING AND MONETARY POLICY UNDER ERM 2.

Recent empirical papers point to the relevance of outsourcing and offshoring for the transmission of business cycle shocks and thereby for the conduct of monetary policy. This is especially true for the countries that are about to join the euro, who have to stay for two years in the European Exchange Rate Mechanism (ERM 2) and therefore target inflation and the exchange rate simultaneously. These countries are significantly integrated with third countries through the production chain. How do external shocks originating from a third country affect monetary policy under ERM 2? We analyze a third-country technology shock. Our results show that a Taylor rule extended for an exchange rate term is a good simple rule for production sharing via complements as well as substitutes vis-à-vis the third country. Nevertheless, the costs of ERM 2 in terms of a traditional central bank loss function are considerable. [ABSTRACT FROM AUTHOR]