Currency Union Flashcards
What is a currency union
an agreement among members to share A common currency, A common interest rate, and a common exchange rate with the outside world
What does economic integration mean?
the free flow of goods and services and the free flow of labor
What do the benefits and costs of joining a currency union boil down to?
the microeconomic benefits of joining in terms of exchange rate stability and eliminated transaction costs and the macroeconomic costs in terms of loss of monetary independence
the euro crisis was very rapidly contagious – what were the two factors behind this rapid contagion?
It was self-fulfilling and Europe was stuck in a doom-loop
Self-Fulfilling equilibrium in the euro crisis
The situation in Greece and the subsequent bailout led markets to re-assess risk in other countries, especially those with high debt, like Ireland, as the assumption of “too rich to fail” fell apart. Ireland had 90% debt-to-GDP ratio, leading its risk premia to surge, causing interest rates to rise to compensate for the higher risk. Borrowing costs surged and the government had trouble making its interest payments, so was led to the risk of default. Fear of default drove Ireland to the edge of it
The Doom Loop
the housing crisis caused big banks to face insolvency, so governments bailed them out taking on debt, causing fears of government default, so yields on government assets rose as prices fell, and banks, who were the main ones buying government bonds, faced even more insolvency risk
Why was the doom loop not a problem in the US and UK?
There was no transmission from bank insolvency to government debt because they could engage in seignorage, meaning they could print money to pay off debt, which EU countries could not
Why did the doom loop cause sudden stop in capital flows?
The doom loop led to fears that high debt would lead to depleted bailout funds and constrain deposit insurance commitments
What did sudden stop of capital flows cause in the EU?
Banks ran out of cash and no one wanted to deposit money in these banks. The supply of credit shifted left, interest rates increased, meaning firms borrowing rates increased. This meant there was a credit crunch. This was exacerbated by austerity packages meant to prevent things from getting out of hand, especially in Ireland, Spain, and Italy
Economic stabilization in the face of asymmetric shocks can occur via other mechanisms aside from monetary independence if you are in a currency union. The two primary and three secondary factors are…
primary: trade integration and labor mobility
secondary: real wage flexibility, banking unions, fiscal transfers
