On the welfare implications of customs unions in the presence of finance constraints

We examine the welfare effects of a customs union on a small monetary econo my. The role of money is captured by a generalized cash-in-advance constrai nt which allows for non-uniform monetization across sectors. This generates a demand-side distortion which results in a discrepancy between the margin al domestic rate of substitution and the world price. We show that, dependi ng on the economy's inflation rate and the difference between the existing and the optimal tariff rate, trade creation may reduce welfare while trade diversion may improve it.