A Theory of monetary union and financial integration

Luca Fornaro

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: Since the creation of the euro, capital flows among member countries have been large and volatile. Motivated by this fact, I provide a theory connecting the exchange rate regime to financial integration. The key feature of the model is that monetary policy affects the value of collateral that creditors seize upon default. Under flexible exchange rates, national governments can expropriate foreign creditors by depreciating the exchange rate, which induces investors to impose tight constraints on international borrowing. Creating a monetary union, by eliminating this source of currency risk, increases financial integration among member countries. This process, however, does not necessarily lead to higher welfare. The reason is that a high degree of capital mobility can generate multiple equilibria, with bad equilibria characterized by inefficient capital flights. Capital controls or fiscal transfers can eliminate bad equilibria, but their implementation requires international cooperation.

Keywords: Monetary union; international financial integration; exchange rates; optimal currency area; capital flights; euro area. (search for similar items in EconPapers)
JEL-codes: E44 E52 F33 F34 F36 F41 F45 (search for similar items in EconPapers)
Date: 2019-12, Revised 2021-04
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mac, nep-mon, nep-opm and nep-ore
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Related works:
Journal Article: A Theory of Monetary Union and Financial Integration (2022)
Working Paper: A Theory of Monetary Union and Financial Integration (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:upf:upfgen:1677

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