Citation

Discussion Paper Details

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Title: Monetary Union and Financial Integration

Author(s): Luca Fornaro

Publication Date: December 2019

Keyword(s): capital flights, Euro Area, Exchange Rates, International financial integration, monetary union and Optimal Currency Area

Programme Area(s): International Macroeconomics and Finance

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.

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Bibliographic Reference

Fornaro, L. 2019. 'Monetary Union and Financial Integration'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14216