The Common Currency Channel of Risk Sharing

Abstract

I propose a novel channel of international risk sharing: the common currency channel. I theoretically show how the central bank of a currency union can use the common currency to insure member countries against consumption risk from idiosyncratic productivity shocks. Monetary policy determines current account imbalances that are financed through the central bank rather than through the transfer of marketable assets. A trade-off between risk sharing and moral hazard emerges: a central bank that facilitates risk sharing increases the chances that countries will require resource transfers. Optimal monetary policy is thus contingent on the realization of aggregate production and on the severity of the underlying moral hazard friction. Revisiting European Central Bank policies during the Eurocrisis between 2008 and 2014, I find that the common currency channel accounts for up to 60% of risk sharing among Eurozone countries in the early stages of the Eurocrisis.

Keywords: central bank, risk sharing, currency union, monetary policy, moral hazard, Eurosystem, Target

JEL Classification: E58, E65, F32, F45