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Financial Heterogeneity and Monetary Union

Author

Listed:
  • Simon Gilchrist
  • Raphael Schoenle
  • Jae W. Sim
  • Egon Zakrajsek

Abstract

We analyze the economic consequences of forming a monetary union among countries with varying degrees of financial distortions, which interact with the firms' pricing decisions because of customer-market considerations. In response to a financial shock, firms in financially weak countries (the periphery) maintain{{p}}cashflows by raising markups--in both domestic and export markets--while firms in financially strong countries (the core) reduce markups, undercutting their financially constrained competitors to gain market share. When the two regions are experiencing different shocks, common monetary policy results in a substantially higher macroeconomic volatility in the periphery, compared with a flexible exchange rate regime; this translates into a welfare loss for the union as a whole, with the loss borne entirely by the periphery. By helping firms from the core internalize the pecuniary externality engendered by the interaction of financial frictions and customer markets, a unilateral fiscal devaluation by the periphery can improve the union's overall welfare.

Suggested Citation

  • Simon Gilchrist & Raphael Schoenle & Jae W. Sim & Egon Zakrajsek, 2018. "Financial Heterogeneity and Monetary Union," Finance and Economics Discussion Series 2018-043, Board of Governors of the Federal Reserve System (U.S.), revised 26 Jun 2018.
  • Handle: RePEc:fip:fedgfe:2018-43
    DOI: 10.17016/FEDS.2018.043
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    References listed on IDEAS

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    1. Simon Gilchrist & Raphael Schoenle & Jae Sim & Egon Zakrajšek, 2017. "Inflation Dynamics during the Financial Crisis," American Economic Review, American Economic Association, vol. 107(3), pages 785-823, March.
    2. Auer, Raphael A. & Schoenle, Raphael S., 2016. "Market structure and exchange rate pass-through," Journal of International Economics, Elsevier, vol. 98(C), pages 60-77.
    3. Raphael A. Auer, 2014. "What drives TARGET2 balances? Evidence from a panel analysis," Economic Policy, CEPR;CES;MSH, vol. 29(77), pages 139-197, January.
    4. Ravn, Morten O. & Schmitt-Grohe, Stephanie & Uribe, Martín & Uuskula, Lenno, 2010. "Deep habits and the dynamic effects of monetary policy shocks," Journal of the Japanese and International Economies, Elsevier, vol. 24(2), pages 236-258, June.
    5. Adao, Bernardino & Correia, Isabel & Teles, Pedro, 2009. "On the relevance of exchange rate regimes for stabilization policy," Journal of Economic Theory, Elsevier, vol. 144(4), pages 1468-1488, July.
    6. Morten Ravn & Stephanie Schmitt-Grohé & Martín Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 195-218.
    7. Fernanda Nechio, 2011. "Monetary policy when one size does not fit all," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue june13.
    8. Morten O. Ravn & Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Pricing to Habits and the Law of One Price," American Economic Review, American Economic Association, vol. 97(2), pages 232-238, May.
    9. Robert C. Feenstra & Philip Luck & Maurice Obstfeld & Katheryn N. Russ, 2018. "In Search of the Armington Elasticity," The Review of Economics and Statistics, MIT Press, vol. 100(1), pages 135-150, March.
    10. José Manuel Montero & Alberto Urtasun, 2014. "Price-cost mark-ups in the Spanish economy: a microeconomic perspective," Working Papers 1407, Banco de España;Working Papers Homepage.
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    Cited by:

    1. Jacob, Punnoose & Uusküla, Lenno, 2019. "Deep habits and exchange rate pass-through," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 67-89.
    2. Kriwoluzky, Alexander & Müller, Gernot J. & Wolf, Martin, 2019. "Exit expectations and debt crises in currency unions," Journal of International Economics, Elsevier, vol. 121(C).
    3. Kuvshinov, Dmitry & Müller, Gernot J. & Wolf, Martin, 2016. "Deleveraging, deflation and depreciation in the euro area," European Economic Review, Elsevier, vol. 88(C), pages 42-66.
    4. Nadav Ben Zeev & Ohad Raveh, 2017. "Monetary Policy, Fisal Federalism, and Capital Intensity," OxCarre Working Papers 181, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford.
    5. Lena Kraus & Juergen Beier & Bernhard Herz, 2018. "Sudden stops inside and outside the euro area - what a difference TARGET2 makes," GRU Working Paper Series GRU_2018_002, City University of Hong Kong, Department of Economics and Finance, Global Research Unit.
    6. Antoun de Almeida, Luiza, 2015. "Firms’ balance sheets and sectoral inflation in the euro area during the financial crisis," Economics Letters, Elsevier, vol. 135(C), pages 31-33.

    More about this item

    Keywords

    Fiscal devaluation; Eurozone; Financial crisis; Markups; Inflation dynamics; Monetary union;

    JEL classification:

    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles

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