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Financial Heterogeneity and Monetary Union

Jae Sim, Raphael Schoenle, Egon Zakrajsek () and Simon Gilchrist ()
Additional contact information
Jae Sim: Federal Reserve Board
Raphael Schoenle: Brandeis University

No 1327, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper, we analyze the business cycle and welfare consequences of monetary union among countries that face heterogeneous financial market frictions. We show that facing financial distress in the absence of devaluation, the firms in financially weak countries countries have an incentive to raise their prices to cope with liquidity shortfalls. At the same time, firms in countries with greater financial slack poach from the customer base of the former countries by undercutting their prices, without internalizing the detrimental effects on union-wide aggregate demand. Thus, a monetary union among countries with heterogeneous degrees of financial frictions may create a tendency toward internal devaluation for core countries with greater financial resources, leading to chronic current account deficits of the peripheral countries. A risk-sharing arrangement between the core and the periphery can potentially undo the distortion brought about by the currency union. However, such risk sharing requires unrealistic amounts of wealth transfers from the core to the periphery. We show that unilateral fiscal devaluation carried out by the peripheral countries can substantially improve the situation not only for themselves but also for the core countries if there exists an important degree of pecuniary externality not internalized by the predatory pricing strategies of individual firms.

New Economics Papers: this item is included in nep-dge, nep-eec, nep-mac, nep-mon and nep-opm
Date: 2015
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Working Paper: Financial Heterogeneity and Monetary Union (2018) Downloads
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