Working Paper: CEPR ID: DP14216
Authors: Luca Fornaro
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: monetary union; international financial integration; exchange rates; optimal currency area; capital flights; euro area
JEL Codes: E44; E52; F33; F34; F36; F41; F45
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary Union (F36) | Financial Integration (F30) |
| Monetary Union (F36) | Borrowing Capacity (G51) |
| Borrowing Capacity (G51) | Financial Integration (F30) |
| Monetary Policy (E52) | Value of Collateral (G32) |
| Value of Collateral (G32) | International Capital Flows (F32) |
| Financial Integration (F30) | Welfare (I38) |
| High Financial Integration (F30) | Multiple Equilibria (D59) |
| Multiple Equilibria (D59) | Inefficient Capital Flights (F32) |