Working paper

Fragmented Monetary Unions

Published on the 23rd of December 2024
Authors : Luca Fornaro , Christoph Grosse Steffen

Working Paper Series no. 978. We provide a theory of financial fragmentation in monetary unions. Our key insight is that currency unions may experience endogenous breakings of symmetry: that is episodes in which identical countries react differently when exposed to the same shock. During these events, part of the union suffers a capital flight, while the rest acts as a safe haven and receives capital inflows. The central bank then faces a difficult trade-off between containing unemployment in capital-flight countries and inflationary pressures in safe-haven ones. By counteracting private capital flows with public ones, anti-fragmentation monetary programs mitigate the impact of financial fragmentation on employment and inflation, thus helping the central bank to fulfil its price stability mandate.

Figure 1. Financial fragmentation acts as shifter of the union-wide Phillips curve
Image WP978
Note: The diagram denotes labor on the x-axis and inflation on the y-axis. The PC_sym schedule refers to the union-wide Phillips curve when the equilibrium is symmetric, while the PC_frag schedule shows the union-wide Phillips curve under financial fragmentation. The central bank can no longer simultaneously achieve full employment and the inflation target in case of fragmentation. For illustration, a dovish central bank targets full employment in all countries of the monetary union, while a hawkish central bank achieves the inflation target, standardized to zero inflation, in the capital-receiving country. Optimal monetary policy will have to trade-off the two competing objectives along the PC_frag schedule..

Financial fragmentation is a recurrent topic in the euro area since the European debt crisis of 2010/12. Though the concept of fragmentation is not easily pinned down, policymakers define it as episodes in which financing conditions and capital flows diverge across member countries due to self-fulfilling market dynamics that decouple macroeconomic outcomes from fundamentals. As a result, monetary policy transmission is impaired, thereby threatening price stability since a single monetary policy is ill suited to deal with the arising asymmetries.

This paper provides a theory for financial fragmentation in monetary unions that combines a role for animal spirits in the determination in capital flow dynamics and financing conditions in monetary unions with implications for prices, employment, and the conduct of monetary policy. Our key insight is that currency unions may experience endogenous breaking of symmetry, which are episodes in which identical countries react differently when exposed to the same shock, purely from intrinsic forces. We find that the shape of equilibrium at the union level is determined by fundamentals. While good fundamentals lead to symmetric outcomes, the picture changes dramatically with bad fundamentals.

With bad fundamentals, animal spirits lead to episodes of fragmentation in which parts of the union suffer a capital flight, leading to low investment and employment, while the rest acts as a safe haven and receives capital inflows. Financial fragmentation thus acts like an asymmetric demand shock. The outcome is a combination of low employment and inflation above target at the union level. In other words, the monetary union experiences a cost-push shock. Since the central bank can address higher inflation only by pushing down demand in both countries, policymakers face a worse inflation-employment trade-off compared to a symmetric union (Figure 1). This is a significant threat to price stability, as it makes the task for the central bank harder to pursue its mandate.

There are two important ingredients for the mechanism in our model to operate. First, financial integration is imperfect, such that the return to investment may differ across the countries in the union. Second, fiscal policy plays an important role, in particular in the absence of a fiscal union. When a country is expected to enter a fiscal crisis, agents start anticipating that the government will have to tax capital income, which triggers beliefs that returns to capital diverge between countries. With financial integration, an amplification mechanism kicks in through capital flight that erodes the domestic tax base, further feeding into beliefs of lower returns to capital from higher tax rates.

We use the framework to analyse anti-fragmentation policies in the form of a flexible allocation of the monetary income among national governments. By counteracting private capital flows with public ones, a central bank can mitigate the effects of fragmentation. Public flows crowd-in private ones, increasing the effectiveness of the tool. Two cases are shown. First, with full fiscal backing and a commitment on the side of central banks to prevent fragmentation, self-fulfilling adverse dynamics disappear completely and the union is stabilized on the symmetric equilibrium. Second, without full fiscal backing, anti-fragmentation tools still mitigate the rise in inflation and unemployment caused by financial fragmentation. However, involved transfers render international cooperation pivotal for the successful implementation. Overall, we find that conventional and anti-fragmentation monetary tools complement each other in maintaining price stability within the monetary union. 

 

Keywords: Monetary Unions, Euro Area, Fragmentation, Optimal Monetary Policy in Open Economies, Capital Flows, Fiscal Crises, Anti-Fragmentation Policies, Inflation, Endogenous Breaking of Symmetry, Optimal Currency Areas
JEL classification: E31, E52, F32, F41, F42, F45

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Updated on the 23rd of December 2024