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Paper #1677

A Theory of monetary union and financial integration
Luca Fornaro
Desembre 2019 (Revisió: Abril 2021)
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 upon default. Under flexible exchange rates, national governments can expropriate foreign creditors by depreciating the exchange rate, which induces investors to impose tight constraints on international borrowing. Creating a monetary union, by eliminating this source of currency risk, increases financial integration among member countries. This process, however, does not necessarily lead to higher welfare. The reason is that a high degree of capital mobility 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.
Paraules clau:
Monetary union, international financial integration, exchange rates, optimal currency area, capital flights, euro area.
Codis JEL:
E44, E52, F33, F34, F36, F41, F45
Àrea de Recerca:
Macroeconomia i Economia Internacional
Publicat a:
The Review of Economic Studies, 89 (4), 2022, 1911-1947
Previously circulated as “Monetary Union and Financial Integration”

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