Financial frictions and optimal stabilization policy in a monetary union

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.     

Monetary and real shocks in a monetary Union: The Swiss case

We analyze to what extent real and monetary shocks affect price levels and real exchange rates in seven Swiss regions. A structural time series model is set up and estimated using the Kalman filter under two assumptions on the persistence of monetary shocks. We find that the variability of changes in price levels is mainly due to real shocks. The variance of monetary shocks is small but the monetary component of inflation differences across regions differs from zero with some persistence. As the Swiss case shows this does not seem to be a major obstacle to forming a monetary union.We thank Ernst Baltensperger, Tobias Rötheli, and participants at the Econometric Society European Meeting 1994 for stimulating discussions. The paper has also benefitted from constructive comments of two anonymous referees. Both authors gratefully acknowledge financial support provided by the Swiss National Foundation through Grants no: 8210-040206 (T.J.) and 12-40498.94 (C.L.).     

FINANCIAL MARKET INTEGRATION AND BUSINESS CYCLE VOLATILITY IN A MONETARY UNION

This paper uses a dynamic general equilibrium two‐country sticky‐price model to analyze the implications of financial market integration for the propagation of asymmetric productivity and government spending shocks in a monetary union. Financial market integration has a small effect on the propagation of these shocks if households can only trade in risk‐free bonds. However, financial market integration has a more substantial effect on the propagation of these shocks in a monetary union with a complete market for state‐contingent claims. This result indicates that it may be important to account for threshold effects in empirical analyses of the impact of financial market integration on business cycle volatility in a monetary union.     

On the feasibility of monetary union: Does it make sense to look for shocks symmetry across countries when none of the countries constitutes an optimum currency area?

Usually, a monetary union is not considered feasible between countries if the correlations of shocks are positive but weak. This may not be so if the country with the larger output gap converges to full-employment equilibrium faster than the country with the smaller gap. We argue that common monetary policy can be destabilizing when countries' responses to non-monetary shocks are perfectly symmetric with a correlation of 1 but exhibit differing investment sensitivities to the real interest rate. We use Canada, Mexico and the United States to test the feasibility of a monetary union by documenting whether: 1) gross investments in Canada and Mexico are equally responsive to the real fund rate, and 2) Canada and Mexico's output growth and inflation respond differently to US monetary policy shocks and oil price shocks. This approach implicitly dictates whether the shocks themselves are symmetric or asymmetric. Using quarterly data and SVAR methodology, we conducted two layers of analysis. We estimated SVARs for the periods 1970–2008, 1970–1990 and 1991–2008 to find that a monetary union is feasible between Canada and the US for the first two sample periods. For Canada and Mexico, we find similar responses of output growth to US monetary policy shocks. We conducted further robustness tests by estimating two identified VARs with common US variables and oil prices for Canada and Mexico to assess commonality in responses to shocks with the US. These results affirm that a monetary union is also feasible between Canada and the US.     

Heterogeneity and convergence of regional inflation (prices)

It is generally thought that members in a monetary union experience a similar level of inflation. This paper verifies this conventional belief. Using regional data, we present statistical evidence of heterogeneous inflation in Japan. Not only does the average inflation differ significantly across regions, but regional inflation responds differently to common economic and monetary factors. Furthermore, we show no evidence of price convergence in the entire group of regions although there is some evidence of convergence in subgroups. These results suggest that diversified regional inflation can exist within a monetary union.     

Fiscal Transfers in a Monetary Union with Exit Option

It is widely debated whether a monetary union has to be accompanied by a fiscal transfer scheme to accommodate asymmetric shocks. We build a model of a monetary union with a central bank and two heterogeneous countries that are linked by a fiscal transfer scheme with repercussions on monetary policy. A central bank aiming at securing the existence of a monetary union in the presence of asymmetric shocks has to compensate single countries for the tax distortions arising from fiscal transfers. Monetary policy may become more expansionary or restrictive depending on asymmetries between member countries' inflation aversion and exit costs.     

The endogeneity of the Optimum Currency Area criteria in East Asia

The Asian financial crisis in mid-1997 has increased interest in policies to achieve greater regional exchange rate stability in East Asia. It has renewed calls for greater monetary and exchange rate cooperation. A country's suitability to join a monetary union depends, inter alia, on the trade intensity and the business cycle synchronization with other potential members of the monetary union. However, these two Optimum Currency Area criteria are endogenous. Theoretically, the effect of increased trade integration (after the elimination of exchange fluctuations among the countries in the region) on the business cycle synchronization is ambiguous. Reduction in trade barriers can potentially increase industrial specialization by country and therefore resulting in more asymmetry business cycles from industry-specific shocks. On the other hand, increased trade integration may result in more highly correlated business cycles due to common demand shocks or intra-industry trade. If the second hypothesis is empirically verified, policy makers have little to worry about the region being unsynchronized in their business cycles as the business cycles will become more synchronized after the monetary union is formed. This paper assesses the dynamic relationships between trade, finance, specialization and business cycle synchronization for East Asian economies using a Generalized Method of Moments (GMM) approach. The dynamic panel approach improves on previous efforts to examine the business cycle correlations — trade link using panel procedures, which control for the potential endogeneity of all explanatory variables. Based on the findings on how trade, finance and sectoral specialization have effects on the size of common shocks among countries, potential policies that can help East Asian countries move closer toward a regional currency arrangement can be suggested. The empirical results of this study suggest that there exists scope for East Asia to form a monetary union.     

Monetary Stabilisation Policy in a Monetary Union: Some Simple Analytics

We do two things in this paper. First, we look at some simple models of monetary decision making in a monetary union and ask how much more variable a country's output and inflation is likely to be if it joins the union. We answer this analytically and then go on to 'calibrate' the simple model. The model has few structural equations, but it is useful in allowing us to examine how the variability of output and inflation are likely to change as key parameters change. Our conclusions on this front are likely to be sensitive to model specification. However, we also identify a second best issue concerning the optimal make–up of the monetary union which is likely to be more robust: namely that only when all members of the union have the same structural parameter values (and shocks are perfectly correlated) will it be optimal for a new member to have these same structural parameter values.     

Collateral fluctuations in a monetary economy

This paper studies economy-wide fluctuations that occur endogenously in the presence of monetary and real assets. Using a standard monetary search model, we consider an economy in which agents can increase consumption, over and above what their liquid monetary asset holdings would allow, pledging real assets as collateral for monetary loans. It is shown that, if the liquidation value of real assets is below full market value, a stable cyclical equilibrium can emerge in consumption and capital around the unstable steady state. We also provide conditions for the existence of cycles of higher order, chaos and sunspot equilibria.     

Compatibility between monetary and fiscal policy under EMU

The debate over the Stability and Growth Pact (SGP) as a part of European Monetary Union, has highlighted the need to assess the extent to which fiscal policies of union members should be constrained as a pre-requisite for price stability within the union. In this paper, we develop a two country open economy model, where each country has overlapping generations of finitely lived consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure stability of the real debt stock is greater when consumers are not infinitely lived. In principle, this allows for some compensating behaviour between governments, but we show that the scope for compensation is limited. The monetary authority can abandon its active targeting of inflation to stabilise the debt of at most one fiscal authority, and any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.     

Financial market imperfections and monetary policy strategy

In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank applying the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if interest rate pass-through is incomplete, the central bank can use a narrow monetary aggregate and the discount interest rate as independent and complementary policy instruments to reinforce the credibility of its announcements and the role of inflation target as a nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman's k-percent money growth rule, which can generate dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.     

The optimal choice of monetary policy instruments in a small open economy

Abstract.  This paper studies how the nature of shocks affects the optimal choice of monetary policy instruments in a small open economy. Three classic rules, fixed exchange rates, monetary targeting, and inflation targeting are studied and ranked by comparing with the optimal monetary policy under commitment. We find that the ranking of the simple rules can be mapped to the terms-of-trade variability that the rule allows relative to what a particular shock optimally calls for. It turns out that inflation targeting dominates the other two rules under productivity or velocity shocks, whereas monetary targeting is the best performer under fiscal shocks.     

Forward-looking monetary policy and anticipated shocks to inflation

This paper extends a standard New Keynesian model to describe the effects of anticipated shocks to inflation and forward-looking monetary policy. Using the data generated from this modified model suggests that overlooking these two factors in the standard Cholesky structural vector autoregressive identification scheme will generate a price puzzle. Furthermore, this paper demonstrates that failing to account for these two factors may result in significant estimates of two other explanations of the price puzzle—the cost channel of transmission of monetary policy and indeterminacy due to violation of the Taylor principle—even though neither features in the data generating process.     

The recent boom–bust cycle: The relative contribution of capital flows, credit supply and asset bubbles

We use an estimated open economy DSGE model with financial frictions for the US and the rest of the world to evaluate various competing explanations about the recent boom–bust cycle. We find that the savings glut hypothesis is insufficient for explaining all aspects of the boom in the US. Relatively strong TFP growth and expansionary monetary policy are also not able to explain fully the volatility of corporate and in particular residential investment. We identify bubbles in the stock and housing market as crucial. Concerning the downturn in 2008/2009, the fall in house prices and residential investment only plays a minor role. Mortgage defaults have more explanatory power, especially in a specification of the model with a segregated equity market. Finally, the bursting of the stock market bubble was at least as important in this recession as in 2001. Because of various negative shocks hitting the economy at the same time in 2008/2009 and continued positive technology growth, not only the real interest rate declined but inflation fell rapidly and left insufficient room for monetary policy to play a similar stabilising role as in previous recessions.     

Sources of exchange rate fluctuations with Taylor rule fundamentals

This paper investigates the sources of exchange rate fluctuations when monetary policy follows a Taylor rule interest rate reaction function. We first present a simple dynamic exchange rate model with Taylor rule fundamentals which is triangular in the long-run impacts of shocks to the output market, the interest rate differential, and the Taylor rule. We then proceed to assess the relative importance of various shocks in exchange rate determination by estimating a structural VAR with long-run identification restrictions based on the triangular structure of the model. We find demand shocks to be less important than in earlier VAR studies, with both supply shocks and nominal shocks explaining a substantial part of real exchange rate fluctuations.     

Wage restraint and monetary union

Existing work on wage bargaining predicts more aggressive wage setting under monetary union. This is exemplified by Cukierman and Lippi (2001) who postulate that wages are set having area-wide prices in mind. The insight of aggressive wage behaviour has not been confirmed by the EMU experience, which has been characterised by wage moderation. The present paper investigates the possibility of wage restraint using a monetary union model which, realistically, assumes that trade unions set wages with national prices in mind. Drawing on plausible ranges for all parameter values (and macroeconomic shocks), our simulations show that a monetary union elicits real wages that are broadly comparable to those obtained under monetary autonomy. The confidence bounds around these results are rather wide, in particular including scenarios of wage restraint.     

Macroeconomic Effects of Asset‐Price Shocks in a Globalized Financial Market

In this paper, I study a model in which shocks to asset prices affect the real sector of the economy through a credit channel. As financial markets become internationally integrated, the economy becomes less vulnerable to domestic asset‐price shocks, but more vulnerable to foreign asset‐price shocks. To the extent that monetary policy stabilization is feasible and desirable, the globalization of financial markets shifts the focus of monetary policy from domestic asset prices to worldwide asset prices.     

Overturning Mundell: Fiscal Policy in a Monetary Union

Central to ongoing debates over the desirability of monetary unions is a supposed trade-off, outlined by Mundell (1961) : a monetary union reduces transactions costs but renders stabilization policy less effective. If shocks across countries are sufficiently correlated, then, according to this argument, delegating monetary policy to a single central bank is not very costly and a monetary union is desirable.
This paper explores this argument in a setting with both monetary and fiscal policies. In an economy with monetary policy alone, we confirm the presence of the trade-off and find that indeed a monetary union will not be welfare improving if the correlation of national shocks is too low. However, fiscal interventions by national governments, combined with a central bank that has the ability to commit to monetary policy, overturn these results. In equilibrium, such a monetary union will be welfare improving for any correlation of shocks.     

One Size Must Fit All: National Divergences in a Monetary Union

Should a common central bank in a heterogeneous monetary union base its decisions on EU‐wide averages of economic variables or on national welfare losses? A central bank that minimizes the sum of national welfare losses reacts less to common shocks. Under certain parameter constellations this leads to higher average union‐wide expected welfare and it might thus be preferable that decision‐making is dominated by national representatives. Countries with a transmission mechanism far from the average benefit from an orientation on national welfare losses. For countries with a transmission mechanism close to the average, welfare can be lower in this case.     

Optimal Currency Areas Scottish Economic Society/Royal Bank of Scotland Annual Lecture, 1999

Microeconomic efficiency and market transparency argue in favour of UK membership in EMU and for Scotland’s membership in the UK monetary union and also in EMU. UK seigniorage (government revenues from money issuance) would be boosted by EMU membership. Lender of last resort arrangements would not be substantially affected by UK membership in EMU. The UK is too small and too open to be an optimal currency area. The same point applies even more emphatically to Scotland. The ‘one‐size‐fits‐all’, ‘asymmetric shocks’ and ‘cyclical divergence’ objections to UK membership are based on the misapprehension that independent national monetary policy, and the associated nominal exchange rate flexibility, can be used effectively to offset or even neutralise asymmetric shocks. This ‘fine tuning delusion’ is compounded by a failure to understand that, under a high degree of international financial integration, market‐determined exchange rates are primarily a source of shocks and instability. Instead, opponents of UK membership in EMU view exchange rate flexibility as an effective buffer for adjusting to asymmetric shocks originating elsewhere. I know of no evidence that supports such an optimistic reading of what exchange rate flexibility can deliver under conditions of very high international financial capital mobility. The economic arguments for immediate UK membership in EMU, at an appropriate entry rate, are overwhelming. Monetary union raises important constitutional and political issues. It involves a further surrender of national sovereignty to a supranational institution, the ECB/ESCB. It is essential that this transfer of national sovereignty be perceived as legitimate by those affected by it. In addition, the citizens of the UK have become accustomed to a high standard of openness and accountability of their central bank since it gained operational independence in 1997. The ECB/ESCB must be held to the same high standard, and, while there are grounds for optimism, there still is some way to go there.