Monetary Union and Financial Integration Luca Fornaro CREI, UPF and Barcelona GSE
Research question and motivation • Long-standing debate on costs vs benefits from adopting a common currency • Friedman (1953): flexible exchange rates act as shock absorbers • Ingram (1973): common currency fosters financial integration and leads to a better allocation of capital
International financial integration ratio (1970-2016) Foreign assets + foreign liabilities Euro area EMU 600 United States Japan Euro area (extra) 500 percent of GDP 400 300 200 100 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Research question and motivation • Long-standing debate on costs vs benefits from adopting a common currency • Friedman (1953): flexible exchange rates act as shock absorbers • Ingram (1973): common currency fosters financial integration and leads to a better allocation of capital ◮ But why should the exchange rate regime matter for financial integration? ◮ And does more financial integration necessarily lead to higher welfare?
This paper • Simple model connecting monetary policy and capital flows ◮ Monetary policy has real effects due to nominal rigidities ◮ Output used as collateral in financial transactions
This paper • Simple model connecting monetary policy and capital flows ◮ Monetary policy has real effects due to nominal rigidities ◮ Output used as collateral in financial transactions • Forming a monetary union increases financial integration ◮ Flexible ER: depreciate to expropriate foreign investors ◮ MU: external constraint on monetary policy ( vincolo esterno )
This paper • Simple model connecting monetary policy and capital flows ◮ Monetary policy has real effects due to nominal rigidities ◮ Output used as collateral in financial transactions • Forming a monetary union increases financial integration ◮ Flexible ER: depreciate to expropriate foreign investors ◮ MU: external constraint on monetary policy ( vincolo esterno ) • Impact on capital flows and welfare is ambiguous ◮ Capital-scarce countries can attract more foreign investment... ◮ but they can also suffer episodes of inefficient capital flights
Model
Model • Two countries: home and foreign • Two periods - perfect foresight ◮ Period 0: financial contracts are signed, investment ◮ Period 1: production, settlement of financial contracts and consumption • I will start by describing the model and the equilibrium in period 1
Households • Identical households with utility C T + C 1 − η N 1 − η − L • Budget constraint P T C T + P N C N = P T Y T − P T R + WL • Optimal demand for non-tradables C N = ( P N /P T ) − 1 η • Nominal wage is fixed, hh satisfy firms’ labor demand
Collateral and default • Debt D owed to foreign investors (denominated in tradables) • In case of default, investors recover a fraction κ of income • Payment to foreign investors Y T + W � � �� R = min D, κ L P T
Production and real exchange rate • Non-tradable good produced by competitive firms Y N = L • Zero-profit condition implies P N = W • Real exchange rate p = P N = W P T P T
Market clearing and collateral • Goods market Y N = C N = p − 1 η C T = Y T − min [ D, κ ( Y T + pY N )] • In equilibrium collateral is Y T + p 1 − 1 � � κ η • Assume η > 1: exchange rate depreciation ( ↓ p ) reduces collateral value
Exchange rate regime and financial integration
Flexible exchange rates • Law of one price P T = SP ∗ T → home government controls p • Optimal non-cooperative policy under discretion max C T + Y 1 − η N 1 − η − Y N • Subject to Y N = p − 1 η Y T + p 1 − 1 � � �� C T = Y T − min D, κ η
Flexible exchange rates • Optimal real exchange rate and production ◮ No default: p = Y N = 1 ◮ Default: p = (1 + κ ( η − 1)) − 1 < 1, Y N > 1
Flexible exchange rates • Optimal real exchange rate and production ◮ No default: p = Y N = 1 ◮ Default: p = (1 + κ ( η − 1)) − 1 < 1, Y N > 1 • No default preferred if η 1 η − 1] ≡ ¯ D ≤ κY T + η − 1 [(1 + κ ( η − 1)) D flex
Flexible exchange rates • Optimal real exchange rate and production ◮ No default: p = Y N = 1 ◮ Default: p = (1 + κ ( η − 1)) − 1 < 1, Y N > 1 • No default preferred if η 1 η − 1] ≡ ¯ D ≤ κY T + η − 1 [(1 + κ ( η − 1)) D flex • In equilibrium D ≤ ¯ D flex , Y N = p = 1 • Notice that ¯ D flex < κ ( Y T + pY N )
Debt ceiling- flexible exchange rates collateral 5 ( Y T + 1) 3 4 1 ! 1 2 Y T + p 5 d 7 debt D flex
Monetary union • Benevolent central bank operating under discretion • Common currency implies P T = P ∗ T • Assume W = W ∗ → p = p ∗ , Y N = Y ∗ N • Optimal policy solves Y 1 − η � � N max C T + C ∗ T + 2 1 − η − Y N • Subject to C T + C ∗ T = Y T + Y ∗ T Y N = p − 1 η
Monetary union • Central bank of the union sets p = Y N = 1 • No default preferred if D ≤ κ ( Y T + pY N ) ≡ ¯ D mu
Debt ceiling- monetary union collateral flexible ER monetary union 5 ( Y T + 1) 3 4 1 ! 1 2 Y T + p 5 d 7 7 debt D flex D mu
Monetary union • Central bank of the union sets p = Y N = 1 • No default preferred if D ≤ κ ( Y T + pY N ) ≡ ¯ D mu • Same p and Y N as with flexible exchange rates, but more collateral D mu > ¯ ¯ D flex ¯ mu > ¯ D ∗ D ∗ flex • Forming a monetary union increases financial integration among member countries
Capital flows and welfare
MU and financial integration: the benign view • In period 0 domestic agents have an endowment of N tradable goods • Investing I gives AI tradable goods in period 1 ( A ∗ < A )
MU and financial integration: the benign view • In period 0 domestic agents have an endowment of N tradable goods • Investing I gives AI tradable goods in period 1 ( A ∗ < A ) • Assuming N ∗ sufficiently large, in equilibrium R = A ∗ and D flex /A ∗ with flexible exchange rates ◮ I = N + ¯ D mu /A ∗ in a monetary union ◮ I = N + ¯
MU and financial integration: the benign view • In period 0 domestic agents have an endowment of N tradable goods • Investing I gives AI tradable goods in period 1 ( A ∗ < A ) • Assuming N ∗ sufficiently large, in equilibrium R = A ∗ and D flex /A ∗ with flexible exchange rates ◮ I = N + ¯ D mu /A ∗ in a monetary union ◮ I = N + ¯ • Welfare gains from forming a MU arise if ◮ Member countries are asymmetric ( A � = A ∗ ) ◮ Financial development is limited ( κ is low enough)
MU and financial integration: the not-so-benign view • Home gov. has to spend G units of the T good in period 1 • G is financed with a tax ( τ ≤ ¯ τ ) on domestic capital G = τY T • After-tax return from investment at home � G � �� ≡ ˜ A (1 − τ ) = A 1 − max , ¯ τ A Y T • Fiscal externality → private increasing returns to investment • Potential for coordination failures and capital flights (Eaton, 1987; Velasco, 1996)
Investment decision • Investment decision depends on after-tax return to capital • Three possible cases: � ¯ � if ˜ D A N + A > A ∗ A ∗ � � N − ¯ � � ¯ �� if ˜ D ∗ D Y T = A , A N + A = A ∗ A ∗ A ∗ � N − ¯ � if ˜ D ∗ A A < A ∗ . ˜ A • Lower tax on home capital → higher productions of T at home • Impact of taxes on production depends on financial integration ( ¯ D and ¯ D ∗ )
Equilibrium determination
Equilibrium with flexible exchange rates
Impact of forming a MU
Multiple equilibria under MU
MU and financial integration: the not-so-benign view • Monetary union might lead to volatile capital flows ◮ Better allocation of capital if expectations are optimistic ◮ But episodes of inefficient capital flights might occur - especially in times of large fiscal expenditures • Capital controls or fiscal transfers (European recovery fund) can eliminate bad equilibria
Fiscal transfer G = τY T + T
MU and financial integration: the not-so-benign view • Monetary union might lead to volatile capital flows ◮ Better allocation of capital if expectations are optimistic ◮ But episodes of inefficient capital flights might occur - especially in times of large fiscal expenditures • Capital controls or fiscal transfers (European recovery fund) can eliminate bad equilibria ◮ But not all countries are going to benefit from these policies ◮ Managing financial integration in a currency union requires international cooperation
Conclusion • Simple model connecting monetary policy and capital flows • Forming a monetary union increases financial integration ◮ Benefit: higher access to foreign funds ◮ Cost: inefficient capital flights ◮ International cooperation in policy design crucial • Future research questions ◮ Inefficient use of capital (financial resource curse) ◮ Gross capital flows
Appendix
International financial integration ratio (1970-2016) Foreign assets + foreign liabilities Euro area EMU 600 United States Japan Euro area (extra) 500 percent of GDP 400 300 200 100 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 back
Recommend
More recommend
