Working Paper: NBER ID: w18280
Authors: Ivan Werning; Emmanuel Farhi
Abstract: We study cross-country risk sharing as a second-best problem for members of a currency union using an open economy model with nominal rigidities and provide two key results. First, we show that if financial markets are incomplete, the value of gaining access to any given level of aggregate risk sharing is greater for countries that are members of a currency union. Second, we show that even if financial markets are complete, privately optimal risk sharing is constrained inefficient. A role emerges for government intervention in risk sharing both to guarantee its existence and to influence its operation. The constrained efficient risk sharing arrangement can be implemented by contingent transfers within a fiscal union. We find that the benefits of such a fiscal union are larger, the more asymmetric the shocks affecting the members of the currency union, the more persistent these shocks, and the less open the member economies. Finally we compare the performance of fiscal unions and of other macroeconomic stabilization instruments available in currency unions such as capital controls, government spending, fiscal deficits, and redistribution.
Keywords: Fiscal unions; Risk sharing; Currency union; Government intervention
JEL Codes: E62; E63; F02; F15; F3; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Membership in a currency union (F36) | Perceived value of risk sharing (D81) |
| Existence of a fiscal union (F36) | Improved risk sharing arrangements (G32) |
| Shocks affecting members of a currency union (F36) | Benefits of a fiscal union (F36) |
| Government intervention (O25) | Optimal outcomes in risk sharing (D63) |
| Incomplete financial markets (D52) | Value of risk sharing (D81) |
| Characteristics of economic shocks (E32) | Interaction with fiscal union benefits (F36) |