Monetary Union and Financial Integration Luca Fornaro CREI, UPF and - - PowerPoint PPT Presentation

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)

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 percent of GDP 100 200 300 400 500 600 EMU

Foreign assets + foreign liabilities

Euro area United States Japan Euro area (extra)

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

CT + C1−η

N

1 − η − L

• Budget constraint

PT CT + PNCN = PT YT − PT R + WL

• Optimal demand for non-tradables

CN = (PN/PT )− 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

R = min

• D, κ
• YT + W

PT L

Production and real exchange rate

• Non-tradable good produced by competitive firms

YN = L

• Zero-profit condition implies

PN = W

• Real exchange rate

p = PN PT = W PT

Market clearing and collateral

• Goods market

YN = CN = p− 1

η

CT = YT − min [D, κ (YT + pYN)]

• In equilibrium collateral is

κ

• YT + p1− 1

η

• Assume η > 1: exchange rate depreciation (↓ p) reduces

collateral value

Exchange rate regime and financial integration

Flexible exchange rates

• Law of one price PT = SP ∗

T → home government controls p

• Optimal non-cooperative policy under discretion

max CT + Y 1−η

N

1 − η − YN

• Subject to

YN = p− 1

η

CT = YT − min

• D, κ
• YT + p1− 1

η

Flexible exchange rates

• Optimal real exchange rate and production

◮ No default: p = YN = 1 ◮ Default: p = (1 + κ(η − 1))−1 < 1, YN > 1

Flexible exchange rates

• Optimal real exchange rate and production

◮ No default: p = YN = 1 ◮ Default: p = (1 + κ(η − 1))−1 < 1, YN > 1

• No default preferred if

D ≤ κYT + η η − 1 [(1 + κ(η − 1))

1 η − 1] ≡ ¯

Dflex

Flexible exchange rates

• Optimal real exchange rate and production

◮ No default: p = YN = 1 ◮ Default: p = (1 + κ(η − 1))−1 < 1, YN > 1

• No default preferred if

D ≤ κYT + η η − 1 [(1 + κ(η − 1))

1 η − 1] ≡ ¯

Dflex

• In equilibrium D ≤ ¯

Dflex, YN = p = 1

• Notice that ¯

Dflex < κ(YT + pYN)

Debt ceiling- flexible exchange rates

debt collateral 7 Dflex 5(YT + 1) 5 3 YT + p

1! 1

2

d

4

Monetary union

• Benevolent central bank operating under discretion
• Common currency implies PT = P ∗

T

• Assume W = W ∗ → p = p∗, YN = Y ∗

N

• Optimal policy solves

max CT + C∗

T + 2

• Y 1−η

N

1 − η − YN

• Subject to

CT + C∗

T = YT + Y ∗ T

YN = p− 1

η

Monetary union

• Central bank of the union sets p = YN = 1
• No default preferred if

D ≤ κ(YT + pYN) ≡ ¯ Dmu

Debt ceiling- monetary union

debt collateral 7 Dmu 7 Dflex 5(YT + 1) 5 3 YT + p

1! 1

2

d

4

flexible ER monetary union

Monetary union

• Central bank of the union sets p = YN = 1
• No default preferred if

D ≤ κ(YT + pYN) ≡ ¯ Dmu

• Same p and YN as with flexible exchange rates, but more

collateral ¯ Dmu > ¯ Dflex ¯ D∗

mu > ¯

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

◮ I = N + ¯ Dflex/A∗ with flexible exchange rates ◮ I = N + ¯ Dmu/A∗ in a monetary union

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

◮ I = N + ¯ Dflex/A∗ with flexible exchange rates ◮ I = N + ¯ Dmu/A∗ in a monetary union

• 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 = τYT

• After-tax return from investment at home

A(1 − τ) = A

• 1 − max

G

YT , ¯ τ

• ≡ ˜

A

• 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:

YT =

        

A

• N +

¯ D A∗

• if ˜

A > A∗

• A
• N − ¯

D∗ A∗

• , A
• N +

¯ D A∗

• if ˜

A = A∗ A

• N − ¯

D∗ ˜ A

• if ˜

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 = τYT + 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)

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 percent of GDP 100 200 300 400 500 600 EMU

Foreign assets + foreign liabilities

Euro area United States Japan Euro area (extra)

back

MU and financial integration: the not-so-benign view

• Assume that A depends on aggregate investment

A =

• Al < A∗

if I ≤ ¯ I Ah > A∗ if I > ¯ I

• Individual behavior depends on expectations of aggregate

investment

◮ If E(I) > ¯ I borrow up to the limit and invest at home ◮ If E(I) ≤ ¯ I send as much capital as possible abroad

• Scope for coordination failures

Equilibrium investment - flexible exchange rates

E(I) I N +

7 Dflex A$

N !

7 D$

flex

Al

7 I

Equilibrium investment - monetary union

E(I) I N +

7 Dmu A$

N !

7 D$

mu

Al

N +

7 Dflex A$

N !

7 D$

flex

Al

7 I

flexible ER monetary union

MU and financial integration: the not-so-benign view

• If financial integration is sufficiently high, pessimistic

expectations trigger capital flights

◮ Expectations of low return on domestic investment ◮ Large capital flights toward foreign economy ◮ Low domestic investment ◮ Low return on domestic investment

• When a monetary union is formed

◮ Better allocation of capital if expectations are optimistic ◮ Bad equilibrium with capital flights becomes possible