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Financial Heterogeneity and Monetary Union

Author

Listed:
  • jae sim

    (Federal Reserve Board)

  • Raphael Schoenle

    (Brandeis University)

  • Egon Zakrajsek

    (Federal Reserve Board)

  • Simon Gilchrist

    (Boston University)

Abstract

In this paper, we analyze the business cycle and welfare consequences of monetary union among countries that face heterogeneous financial market frictions. We show that facing financial distress in the absence of devaluation, the firms in financially weak countries countries have an incentive to raise their prices to cope with liquidity shortfalls. At the same time, firms in countries with greater financial slack poach from the customer base of the former countries by undercutting their prices, without internalizing the detrimental effects on union-wide aggregate demand. Thus, a monetary union among countries with heterogeneous degrees of financial frictions may create a tendency toward internal devaluation for core countries with greater financial resources, leading to chronic current account deficits of the peripheral countries. A risk-sharing arrangement between the core and the periphery can potentially undo the distortion brought about by the currency union. However, such risk sharing requires unrealistic amounts of wealth transfers from the core to the periphery. We show that unilateral fiscal devaluation carried out by the peripheral countries can substantially improve the situation not only for themselves but also for the core countries if there exists an important degree of pecuniary externality not internalized by the predatory pricing strategies of individual firms.

Suggested Citation

  • jae sim & Raphael Schoenle & Egon Zakrajsek & Simon Gilchrist, 2015. "Financial Heterogeneity and Monetary Union," 2015 Meeting Papers 1327, Society for Economic Dynamics.
  • Handle: RePEc:red:sed015:1327
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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. 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.
    4. Ioana A. Duca & José M. Montero & Marianna Riggi & Roberta Zizza, 2017. "I will survive. Pricing strategies of financially distressed firms," Temi di discussione (Economic working papers) 1106, Bank of Italy, Economic Research and International Relations Area.
    5. Fernanda Nechio, 2011. "Monetary policy when one size does not fit all," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue june13.
    6. 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.
    7. José Manuel Montero & Alberto Urtasun, 2014. "Price-cost mark-ups in the Spanish economy: a microeconomic perspective," Working Papers 1407, Banco de España.
    8. 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.
    9. Morten Ravn & Stephanie Schmitt-Grohé & Martín Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 195-218.
    10. 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.
    11. Raphael A. Auer, 2014. "What drives TARGET2 balances? Evidence from a panel analysis [What drives Target2 balances? Evidence from a panel analysis]," Economic Policy, CEPR;CES;MSH, vol. 29(77), pages 139-197.
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    Cited by:

    1. 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.
    2. 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.
    3. 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.
    4. Kobielarz, Michal, 2018. "The economics of monetary unions," Other publications TiSEM b0293536-68ec-4905-bffd-6, Tilburg University, School of Economics and Management.
    5. Kriwoluzky, Alexander & Müller, Gernot J. & Wolf, Martin, 2019. "Exit expectations and debt crises in currency unions," Journal of International Economics, Elsevier, vol. 121(C).
    6. José Manuel Montero, 2017. "Pricing decisions under financial frictions: evidence from the wdn survey," Working Papers 1724, Banco de España.
    7. Martin Wolf, 2018. "Optimal Prudential Policy in Economies with Downward Wage Rigidity," Vienna Economics Papers 1804, University of Vienna, Department of Economics.
    8. Ohad Raveh, 2016. "Monetary Policy, Fisal Federalism, and Capital Intensity," OxCarre Working Papers 181, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford.
    9. Leena Rudanko, 2017. "Pricing in a Frictional Product Market," 2017 Meeting Papers 1281, Society for Economic Dynamics.

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    More about this item

    JEL classification:

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

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