An Imperfect Financial Union with Heterogeneous Regions

67 Pages Posted: 16 Oct 2018

See all articles by Filippo Balestrieri

Filippo Balestrieri

Analysis Group, Inc.

Suman Sambha Basu

International Monetary Fund (IMF)

Date Written: September 2018

Abstract

We analyze a union of financially-integrated yet politically-sovereign countries, where households in the Northern core of the union lend to those in the Southern periphery in a unified debt market subject to a borrowing constraint. This constraint generates sudden stops throughout the South, depresses the intra-union interest rate, and reduces Northern welfare below its unconstrained level, while having ambiguous effects on Southern welfare. During sudden stops, Pareto improvements can be achieved using North-to-South governmental loans if Southern governments have the capacity to commit to repay, or using a combination of Southern debt relief and budget-neutral taxes and subsidies if they do not. From the pre-crisis perspective, it is Pareto-improving to allow loans and debt relief to be negotiated in later sudden-stop periods as long as the regions in the union are sufficiently heterogeneous to begin with. We show that our results are robust to production and to limited financial openness of the union.

Keywords: Capital flows, sudden stop, financial union, heterogeneous regions, Financial Markets and the Macroeconomy, Financial Aspects of Economic Integration, International Policy Coordination and Transmission

JEL Classification: E44, F36, F42

Suggested Citation

Balestrieri, Filippo and Basu, Suman Sambha, An Imperfect Financial Union with Heterogeneous Regions (September 2018). IMF Working Paper No. 18/205, Available at SSRN: https://ssrn.com/abstract=3267232

Filippo Balestrieri (Contact Author)

Analysis Group, Inc. ( email )

111 Huntington Avenue
10th floor
Boston, MA 02199
United States

Suman Sambha Basu

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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