Monetary Union and Financial Integration

36 Pages Posted: 14 Jan 2020

See all articles by Luca Fornaro

Luca Fornaro

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Barcelona Graduate School of Economics (Barcelona GSE)

Date Written: December 2019

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 in case of default. Under flexible exchange rates, national governments can expropriate foreign investors by depreciating the exchange rate. Anticipating this, investors impose tight limits on international borrowing. In a monetary union this source of exchange rate risk is absent, because national governments do not control monetary policy. Forming a monetary union thus increases financial integration by boosting borrowing capacity toward foreign investors. This process, however, does not necessarily lead to higher welfare. The reason is that a high degree of financial integration 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: capital flights, Euro Area, Exchange Rates, International financial integration, monetary union, Optimal Currency Area

JEL Classification: E44, E52, F33, F34, F36, F41, F45

Suggested Citation

Fornaro, Luca, Monetary Union and Financial Integration (December 2019). CEPR Discussion Paper No. DP14216, Available at SSRN: https://ssrn.com/abstract=3518554

Luca Fornaro (Contact Author)

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

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