nep-cba New Economics Papers
on Central Banking
Issue of 2013‒03‒16
25 papers chosen by
Maria Semenova
Higher School of Economics

  1. Interest Rate Expectations in the Media and Central Bank Communication By Michael J. Lamla; Jan-Egbert Sturm
  2. International Financial Reforms : Capital Standards, Resolution Regimes and Supervisory Colleges, and their Effect on Emerging Markets By Duncan Alford
  3. Tailoring Bank Capital Regulation for Tail Risk By Nataliya Klimenko
  4. Monetary Policy, Inflation Illusion and the Taylor Principle – An Experimental Study By Wolfgang J. Luhan; Johann Scharler
  5. Testing for optimal monetary policy via moment inequalities By Laura Coroneo; Valentina Corradi; Paulo Santos Monteiro
  6. Central Bank Independence and the Signaling Effect of Intervention: A Preliminary Exploration By Shinji Takagi; Hiroki Okada
  7. Recessions after Systemic Banking Crises: Does it matter how Governments intervene? By Sweder van Wijnbergen; Timotej Homar
  8. Should Central Banks publish interest rate forecasts? - A Survey By Phan, Tuan
  9. Speculative Runs on Interest Rate Pegs By Marco Bassetto; Christopher Phelan
  10. A macroprudential approach to address liquidity risk with the Loan-to-Deposit ratio By Jan Willem van den End
  11. The Real Consequences of Financial Stress By Stefan Mittnik; Willi Semmler; ;
  12. Banks Exposure to Interest Rate Risk and The Transmission of Monetary Policy By Augustin Landier; David Sraer; David Thesmar
  13. China's Monetary Policy Communication: Money Markets not only Listen, They also Understand By Alicia Garcia-Herrero; Eric Girardin
  14. Does Easing Monetary Policy Increase Financial Instability? By Ambrogio Cesa-Bianchi; Alessandro Rebucci
  15. Estimating bank default with generalised extreme value models By Raffaella Calabrese; Paolo Giudici
  16. Fiscal Limits and Monetary Policy By Eric M. Leeper
  17. Towards a New EMU By Fritz Breuss
  18. Business cycle and monetary policy analysis with market rigidities and financial frictions By M. Casares; Luca Deidda; JE. Galdon-Sanchez
  19. From supervision to resolution: next steps on the road to European banking union By Nicolas Véron; Guntram B. Wolff
  20. How Much Has Private Credit Lending Reacted to Monetary Policy in China? The Case of Wenzhou By Duo Qin; Zhong Xu; Xue-Chun Zhang
  21. The International Monetary System in Flux: Overview and Prospects By Pedro Bação; António Portugal Durate; Mariana Simões
  22. Understanding Operational Risk Capital Approximations: First and Second Orders By Gareth W. Peters; Rodrigo S. Targino; Pavel V. Shevchenko
  23. Monetary Neutrality under Evolutionary Dominance of Bounded Rationality By Gilberto Tadeu Lima; Jaylson Jair da Silveira
  24. The Impact of Market Regulations on Intra-European Real Exchange Rates By Agnès Bénassy-Quéré; Dramane Coulibaly
  25. A Transfer Mechanism for a Monetary Union By Philipp Engler; Simon Voigts; ;

  1. By: Michael J. Lamla (KOF Swiss Economic Institute, ETH Zurich, Switzerland); Jan-Egbert Sturm (KOF Swiss Economic Institute, ETH Zurich, Switzerland)
    Abstract: While there is ample evidence how central bank communication and interest rate decisions are perceived by financial markets, insights regarding the response of the public is lacking. Media is known to be an important transmitter of news to the public. Based on articles in the Financial Times Europe, we test how expectations on the future course of monetary policy presented in the media are affected by central bank communication and interest rate decisions.
    Keywords: European Central Bank, monetary policy announcements, central bank communication, media expectations
    JEL: E52 E58
    Date: 2013–03
  2. By: Duncan Alford (Asian Development Bank Institute (ADBI))
    Abstract: This paper focuses on the relevance to emerging economies of three major financial reforms following the global financial crisis of 2007–2009 : (1) the improved capital requirements intended to reduce the risk of bank failure (“Basel IIIâ€), (2) the improved recovery and resolution regimes for global banks, and (3) the development of supervisory colleges of cross-border financial institutions to improve supervisory cooperation and convergence. The paper also addresses the implications of these regulatory reforms for Asian emerging markets.
    Keywords: Asian Emerging Markets, Financial Reforms, G20, Basel III, Financial supervision
    JEL: G2 G28 O16
    Date: 2013–01
  3. By: Nataliya Klimenko (AMSE - Aix-Marseille School of Economics - Aix-Marseille Univ. - Centre national de la recherche scientifique (CNRS) - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - Ecole Centrale Marseille (ECM))
    Abstract: The experience of the 2007-09 financial crisis has showed that the bank capital regulation in place was inadequate to deal with "manufacturing" tail risk in the financial sector. This paper proposes an incentive-based design of bank capital regulation aimed at efficiently dealing with tail risk engendered by bank top managers. It has two specific features: (i) first, it incorporates information on the optimal incentive contract between bank shareholders and bank managers, thereby dealing with the internal agency problem; (ii) second, it relies on the mechanism of mandatory recapitalization to ensure this contract is adopted by bank shareholders.
    Keywords: capital requirements; tail risk; recapitalization; incentive compensation; moral hazard
    Date: 2013–02
  4. By: Wolfgang J. Luhan; Johann Scharler
    Abstract: We develop a simple experimental setting to evaluate the role of the Taylor principle, which holds that the nominal interest rate has to respond more than one-for-one to fluctuations in the inflation rate. In our setting, the average inflation rate fluctuates around the inflation target if the computerized central bank obeys the Taylor principle. If the Taylor principle is violated, then the average inflation rate persistently deviates from the target. We find that these deviations from the target are less pronounced, if inflation rates cannot be as readily observed as nominal interest rates. This result is consistent with the interpretation that subjects underestimate the influence of inflation on the real return to savings if the inflation rate is only observed ex post.
    Keywords: Taylor principle; interest rate rule; inflation illusion; laboratory experiment
    JEL: E30 E52 C90
    Date: 2013–02
  5. By: Laura Coroneo; Valentina Corradi; Paulo Santos Monteiro
    Abstract: The specification of an optimizing model of the monetary transmission mechanism requires selecting a policy regime, commonly commitment or discretion. In this paper we propose a new procedure for testing optimal monetary policy, relying on moment inequalities that nest commitment and discretion as two special cases. The approach is based on the derivation of bounds for inflation that are consistent with optimal policy under either policy regime. We derive testable implications that allow for specification tests and discrimination between the two alternative regimes. The proposed procedure is implemented to examine the conduct of monetary policy in the United States economy.
    Keywords: Bootstrap; GMM; Moment Inequalities; Optimal Monetary Policy
    JEL: C12 C52 E52 E58
    Date: 2013–03
  6. By: Shinji Takagi (Graduate School of Economics, Osaka University); Hiroki Okada (Graduate School of Economics, Osaka University)
    Abstract: This note explores the signaling effect of foreign exchange market intervention in countries, such as Japan, the United Kingdom and the United States, where separate agencies are responsible for intervention and monetary policy. An important part of the signaling effect operates when an entity conducting intervention makes a credible commitment to a change in future monetary policy, suggesting that its effectiveness hinges upon whether the central bank is independent of government oversight. We test this conjecture by comparing the consistency of intervention and future monetary policy in Japan before and after April 1998, when central bank independence was established by the new Bank of Japan Law. As expected, the signaling effect of intervention weakened after the central bank became independent.
    Keywords: foreign exchange market intervention; Japanese intervention; central bank independence; signaling effect of intervention
    JEL: E42 F31 F33
    Date: 2013–03
  7. By: Sweder van Wijnbergen (University of Amsterdam); Timotej Homar (University of Amsterdam)
    Abstract: Systemic banking crises often continue into recessions with large output losses (Reinhart & Rogoff 2009a). In this paper we ask whether the way Governments intervene in the financial sector has an impact on the economy's subsequent performance. Our theoretical analysis focuses on bank incentives to manage bad loans. We show that interventions involving bank restructuring provide banks with incentives to restructure bad loans and free up resources for new economic activity. Other interventions lead banks to roll over bad loans, tying up resources in distressed firms. Our analysis suggests that zombie banks are a drag on economic recovery. We then analyze 65 systemic banking crises from the period 1980-2012, of which 25 are part of the recent global financial crisis, to answer the question: how effective are intervention measures from the macro perspective, in particular how do they affect recession duration? We find that bank restructuring, which includes bank recapitalizations, significantly reduces recession duration. The effect of liquidity support on the probability of recovery is positive but smaller. Blanket guarantees on bank liabilities and monetary policy do not have a significant effect.
    Keywords: Financial crises; intervention policies; zombie banks; economic recovery; bank restructuring; bank recapitalization
    JEL: E44 E58 G21 G28
    Date: 2013–03–04
  8. By: Phan, Tuan
    Abstract: As a particular form of transparency, nowadays some central banks publish their interest rate forecasts while many others refuse to do that. Whether the publication is good or bad for economic performance and social welfares is now a hotly debatable subject. This paper provides a review of the literature in both theoretical and empirical aspects. We also establish a criteria table which could be used as a preliminary guideline for central banks in answering the question whether they should reveal the forecasts, and how to publish the policy rate inclinations. The suggested conclusion is that interest rate projections should be considered as one of the last items that central banks should reveal and they should be very careful in publishing its policy rate forecasts.
    Keywords: Central bank, transparency, interest rate forecasts
    JEL: E58
    Date: 2013–03–01
  9. By: Marco Bassetto; Christopher Phelan
    Abstract: In this paper we show that interest rate rules lead to multiple equilibria when the central bank faces a limit to its ability to print money, or when private agents are limited in the amount of bonds that can be pledged to the central bank in exchange for money. Some of the equilibria are familiar and common to the environments where limits to money growth are not considered. However, new equilibria emerge, where money growth and inflation are higher. These equilibria involve a run on the central bank's interest target: households borrow as much as possible from the central bank, and the shadow interest rate in the private market is different from the policy target.
    JEL: E42 E43 E52 E61
    Date: 2013–03
  10. By: Jan Willem van den End
    Abstract: This paper maps the empirical features of the Loan-to-Deposit (LTD) ratio with an eye on using it in macroprudential policy to mitigate liquidity risk. We inspect the LTD trends and cycles of 11 euro area countries by filtering methods and analyze the interaction between loans and deposits. We propose that the trend of the LTD ratio is maintained within an upper and lower bound to avoid bad equilibria. To manage the LTD ratio between the boundaries we formulate two macroprudential rules. One that stimulates banks to issue retail deposits in an upturn and one that incentivizes banks to create loanable funds to support lending in a downturn, facilitated by a sufficiently long adjustment period.
    Keywords: Financial stability; Banks; Liquidity; Regulation
    JEL: C15 E44 G21 G32 G28
    Date: 2013–02
  11. By: Stefan Mittnik; Willi Semmler; ;
    Abstract: We introduce a dynamic banking–macro model, which abstains from conventional mean– reversion assumptions and in which—similar to Brunnermeier and Sannikov (2010)—adverse asset–price movements and their impact on risk premia and credit spreads can induce instabilities in the banking sector. To assess such phenomena empirically, we employ a multi–regime vector autoregression (MRVAR) approach rather than conventional linear vector autoregressions. We conduct bivariate empirical analyses, using country–specific financial–stress indices and industrial production, for the U.S., the UK and the four large euro–area countries. Our MRVAR–based impulse–response studies demonstrate that, compared to a linear specification, response profiles are dependent on the current state of the economy as well as the sign and size of shocks. Previous multi–regime–based studies, focusing solely on the regime–dependence of responses, conclude that, during a high–stress period, stress–increasing shocks have more dramatic consequences for economic activity than during low stress. Conducting size–dependent response analysis, we find that this holds only for small shocks and reverses when shocks become sufficiently large to induce immediate regime switches. Our findings also suggest that, in states of high financial stress, large negative shocks to financial–stress have sizeable positive effects on real activity and support the idea of “unconventional” monetary policy measures in cases of extreme financial stress.
    Keywords: banking–sector instability, financial stress, monetary policy, nonlinear VAR, regime dependence
    JEL: E2 E6 C13
    Date: 2013–02
  12. By: Augustin Landier; David Sraer; David Thesmar
    Abstract: We show empirically that banks' exposure to interest rate risk, or income gap, plays a crucial role in monetary policy transmission. In a first step, we show that banks typically retain a large exposure to interest rates that can be predicted with income gap. Secondly, we show that income gap also predicts the sensitivity of bank lending to interest rates. Quantitatively, a 100 basis point increase in the Fed funds rate leads a bank at the 75th percentile of the income gap distribution to increase lending by about 1.6 percentage points annually relative to a bank at the 25th percentile.
    JEL: E51 E52 G2 G21 G3
    Date: 2013–02
  13. By: Alicia Garcia-Herrero (Banco Bilbao Vizcaya Argentaria (BBVA) and Lingnan University and Hong Kong Institute for Monetary Research); Eric Girardin (Aix-Marseille University and French National Center for Scientific Research (CNRS) and ˆ[cole des Hautes ˆ[tudes en Sciences Sociales (EHESS) and Hong Kong Institute for Monetary Research)
    Abstract: Central bank communication is becoming a key aspect of monetary policy as a consequence of financial liberalization and the introduction of market instruments to conduct monetary policy. How much the market listens and, possibly, understands the People's Bank of China (PBoC) should be a key question for the central bank in modernising its monetary policy toolkit. In this paper, we tackle this issue empirically and find that China's money markets not only listen to the PBoC's words but understand the tone of monetary policy which the PBoC intends to convey in its messages. First, we find that the volatility and volume of money market rates change right after communication from the PBoC's governing body. Second, we find a statistically significant rise in interbank rates following communication with a hawkish tone. All in all, our results show strong evidence of effective oral and written communication by the PBoC aimed at China's money markets.
    Keywords: China Monetary Policy Communication, Money Market
    JEL: E52 E58 E43
    Date: 2013–02
  14. By: Ambrogio Cesa-Bianchi; Alessandro Rebucci
    Abstract: This paper develops a model featuring both a macroeconomic and a financial stability objective that speaks to the interaction between monetary and macroprudential policies. First, we find that interest rate rigidities in a monopolistic banking system have an asymmetric impact on financial stability: they lead to greater financial instability in response to contractionary shocks, while they act as an automatic financial stabilizer in response to expansionary shocks. Second, we find that when the policy interest rate is the only instrument, a monetary authority subject to the same constraints as private agents cannot always achieve a (constrained) efficient allocation and faces a trade-off between macroeconomic and financial stability in response to contractionary shocks. This has important implications for the role played by U. S. monetary policy in the run-up to the global financial crisis: the model suggests that the weak link in the U. S. policy framework was not the monetary policy stance after 2002, but rather the absence of an effective second policy pillar aimed at preserving financial stability.
    JEL: E44 E52 E61
    Date: 2013–02
  15. By: Raffaella Calabrese (Department of Quantitative Methods for Economics and Business Sciences, University of Milano-Bicocca); Paolo Giudici (Department of Economics and Management, University of Pavia)
    Abstract: This paper considers the joint role of macroeconomic and bankspecific factors in explaining the occurrence of bank failures. As bank failures are, fortunately, rare, we apply a regression model, based on extreme value theory, that turns out to be more effective than classical logistic regression models. The application of this model to the occurrence of bank defaults in Italy shows that, while capital ratios considered by the regulatory requirements of Basel III are extremely significant to explain proper failures, macroeconomic conditions are relevant only when failures are defined also in terms of merger and acquisition. We also apply the joint beta regression model, in order to estimate the factors that most contribute to the bank capital ratios monitored by Basel III. Our results show that the Tier 1 capital ratio and the Total capital ratio are affected by similar variables, at the micro and macroeconomic level. An important outcome of this part of the analysis is that capital ratio variables can be taken as reasonable proxies of distress, at least as far as the effect sign of the determinants of failure risk is being considered.
    Date: 2013–03
  16. By: Eric M. Leeper
    Abstract: Every economy faces a "fiscal limit" that delivers the maximum government debt-GDP ratio that can be sustained without appreciable risk of default or higher inflation. But governments in advanced economies issue substantial nominal debt and nominal debt is a commitment to repay in nominal units. When such economies are approaching their fiscal limits, debt can be devalued through higher current and future inflation rates. The paper develops a simple bond market supply-demand apparatus to explain how fiscal policy can be a source of inflation, while monetary policy merely determines the timing of inflation.
    JEL: E31 E52 E62 E63
    Date: 2013–03
  17. By: Fritz Breuss (WIFO)
    Abstract: The global financial and economic crisis in 2008-09 followed by a "Euro crisis" – not a crisis of the Euro but a sovereign debt (and/or banking) crisis in some Euro countries – forced to reforms of the asymmetric policy design of the Economic and Monetary Union (EMU). Starting with ad-hoc rescue operations for Greece, Ireland and Portugal a whole bunch of reform steps were necessary to make the Euro area "crisis-proof" for the future. Whether the measures taken are already enough to make the EMU better functioning in future crises is an open question. Nevertheless, the crisis proved to act like Schumpeter's "process of creative destruction": the old (not crisis-proof) institutional set-up has been gradually changed towards a more centralised fiscal policy at EU/Euro area level within a new EMU economic governance. Besides the improvement of the policy instruments of the "Economic Union" of EMU, also the ECB with its monetary policy entered more and more into the role of a lender of last resort of the banking sector. More far-reaching plans (that of Barroso and of Van Rompuy) are already on the table which should transform the European Union from a "Fiscal and Transfer Union" over a "Banking Union" into a genuine EMU with the final goal of a "Political Union", not to mention the "United States of Europe" (USE).
    Keywords: Economic and Monetary Union, Eurozone, European Integration, EU
    Date: 2012–03–06
  18. By: M. Casares; Luca Deidda; JE. Galdon-Sanchez
    Abstract: We examine business cycle fluctuations in a dynamic macroeconomic model that incorporates a financial accelerator mechanism, borrowing constraints, and frictions on both setting prices and wages. After an adverse financial shock, the slow-adjustment process on wage cuts results in higher production marginal costs, lower firm earnings, and a subsequent reduction in equity that explains the increase in the cost of borrowing and the credit crunch. The real effects of adverse financial shocks are significantly amplified when either considering greater rigidities for price/wage setting or a low elasticity of substitution in loan production (real rigidities in the financial sector). In the monetary policy analysis, a Taylor (1983)-style rule performs slightly better when incorporating a small response coefficient to the spread between borrowing and saving interest rates.
    Keywords: financial accelerator; nominal rigidities; real rigidities
    JEL: E44 E32
    Date: 2013
  19. By: Nicolas Véron; Guntram B. Wolff
    Abstract: Listen to the press conference call. The European Council has outlined the creation of a Single Resolution Mechanism (SRM), complementing the Single Supervisory Mechanism. The thinking on the SRMâ??s legal basis, design and mission is still preliminary and depends on other major initiatives, including the European Stability Mechanismâ??s involvement in bank recapitalisations and the Bank Recovery and Resolution (BRR) Directive. The SRM should also not be seen as the final step creating Europeâ??s future banking union. Both the BRR Directive and the SRM should be designed to enable the substantial financial participation of existing creditors in future bank restructurings. To be effective, the SRM should empower a central body. However, in the absence of Treaty change and of further fiscal integration, SRM decisions will need to be implemented through national resolution regimes. The central body of the SRM should be either the European Commission, or a new authority. This legislative effort should not be taken as an excuse to delay decisive action on the management and resolution of the current European banking fragility, which imposes a major drag on Europeâ??s growth and employment.
    Date: 2013–02
  20. By: Duo Qin (Department of Economics, SOAS, University of London, UK); Zhong Xu (People's Bank of China); Xue-Chun Zhang (People's Bank of China)
    Abstract: This study investigates empirically what the major factors are which have driven Wenzhou’s informal credit market and how much that market is responsive to monetary policies and the formal banking conditions nationwide. The main findings are: (i) the informal credit lending rates are highly receptive to monetary policies; (ii) the market is dominantly demand driven; (iii) the informal lending is substitutive to bank savings in the short run but complementary to banking lending in the long run; and (iv) the market is complementary to excessive investments in the local real estate market.
    Keywords: informal credit market, monetary policy
    JEL: G19 E52 O16
    Date: 2013–02
  21. By: Pedro Bação (Faculty of Economics, University of Coimbra and GEMF, Portugal); António Portugal Durate (Faculty of Economics, University of Coimbra and GEMF, Portugal); Mariana Simões (Faculty of Economics, University of Coimbra, Portugal)
    Abstract: This paper analyses the architecture of the International Monetary System (IMS) and the role of reserve currencies in it. We begin by describing the evolution of the IMS from the Gold Standard to the Bretton Woods system and the European integration process that led to the creation of the euro. We then discuss the role played by the euro in the IMS as an international reserve currency. Drawing on econometric estimations, we extrapolate the evolution of the shares in international reserves of the euro, the US dollar and the renminbi. In the discussion, we take into account the current sovereign debt crisis and the possibility of a currency war taking place as a result of the reportedly excessive undervaluation of the renminbi and of the expansionist monetary policies undertaken in several advanced economies, namely in the USA. The text ends with a review of proposals for reducing the likelihood of currency wars, which may disrupt the functioning of the current IMS.
    Keywords: currency war; euro; financial crisis; International Monetary System; exchange rate misalignments.
    JEL: E52 F31 F33 G15
    Date: 2013–01
  22. By: Gareth W. Peters; Rodrigo S. Targino; Pavel V. Shevchenko
    Abstract: We set the context for capital approximation within the framework of the Basel II / III regulatory capital accords. This is particularly topical as the Basel III accord is shortly due to take effect. In this regard, we provide a summary of the role of capital adequacy in the new accord, highlighting along the way the significant loss events that have been attributed to the Operational Risk class that was introduced in the Basel II and III accords. Then we provide a semi-tutorial discussion on the modelling aspects of capital estimation under a Loss Distributional Approach (LDA). Our emphasis is to focus on the important loss processes with regard to those that contribute most to capital, the so called high consequence, low frequency loss processes. This leads us to provide a tutorial overview of heavy tailed loss process modelling in OpRisk under Basel III, with discussion on the implications of such tail assumptions for the severity model in an LDA structure. This provides practitioners with a clear understanding of the features that they may wish to consider when developing OpRisk severity models in practice. From this discussion on heavy tailed severity models, we then develop an understanding of the impact such models have on the right tail asymptotics of the compound loss process and we provide detailed presentation of what are known as first and second order tail approximations for the resulting heavy tailed loss process. From this we develop a tutorial on three key families of risk measures and their equivalent second order asymptotic approximations: Value-at-Risk (Basel III industry standard); Expected Shortfall (ES) and the Spectral Risk Measure. These then form the capital approximations.
    Date: 2013–03
  23. By: Gilberto Tadeu Lima; Jaylson Jair da Silveira
    Abstract: We provide evolutionary game-theoretic microfoundations to a dynamic complete nominal adjustment in response to a monetary shock. To this end, we develop an approach based on a new analytical notion to which we refer as boundedly rational inattentiveness. We investigate the behavior of the price level in an context in which a firm can either pay a cost to update its information set and establish the optimal price (Nash strategy) or freely use information from the previous period and establish a lagged optimal price (bounded rationality strategy). We devise an evolutionary micro-dynamics that, by interacting to the dynamics of the aggregate variables, determines the co-evolution of the distribution of information-updating strategies in the population of firms and the extent of the nominal adjustment of the general price level to a monetary shock. Although the bounded rationality strategy is the only survivor in the long-run evolutionary equilibrium, money is nonetheless neutral. The evolutionary learning dynamics takes the information-updating process to an equilibrium configuration in which, despite all firms play the bounded rationality strategy, the corresponding price level is the symmetric Nash equilibrium price.
    Keywords: bounded rationality; evolutionary dynamics; monetary neutrality
    JEL: E31 C73 D83
    Date: 2013–02–20
  24. By: Agnès Bénassy-Quéré; Dramane Coulibaly
    Abstract: We study the contribution of market regulations in the dynamics of the real exchange rate within the European Union. Based on a model proposed by De Gregorio et al. (1994a), we show that both product market regulations in nontradable sectors and employment protection tend to inflate the real exchange rate. We then carry out an econometric estimation for European countries over 1985-2006 to quantify the contributions of the pure Balassa-Samuelson effect and those of market regulations in real exchange-rate variations. Based on this evidence and on a counter-factual experiment, we conclude that the relative evolution of product market regulations and employment protection across countries play a very significant role in real exchange- rate variations within the European Union and especially within the Euro area, through theirs impacts on the relative price of nontradable goods.
    Keywords: Real exchange rate, Balassa-Samuelson effect, Product market regulations, Employment protection
    JEL: F41 J50 L40
    Date: 2013
  25. By: Philipp Engler; Simon Voigts; ;
    Abstract: We show in a dynamic stochastic general equilibrium framework that the introduction of a common currency by a group of countries with only partially integrated goods markets, incomplete …nancial markets and no labor migration across member states, signi…cantly increases volatility of consumption and employment in the face of asymmetric shocks. We propose a simple transfer mechanism between member countries of the union that reduces this volatility. Further- more, we show that this mechanism is more e¢ cient than anticyclical policies at the national level in terms of a better stabilization for the same budgetary e¤ects for households while in the long run deeper integration of goods markets could reduce volatility signi…cantly. Re- garding its implementation, we show that the centralized provision of public goods and services at the level of the monetary union implies cross-country transfers comparable to the scheme under study.
    Keywords: Monetary Union, Asymmetric Shocks, Fiscal Policy, Fiscal Transfers
    JEL: F41 F44 E2 E3 E52
    Date: 2013–03

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