Financial Heterogeneity and Monetary Union

July 2015
Simon Gilchrist, Raphael Schoenle, Jae Sim, Egon Zakrajˇsek

We analyze the business cycle and welfare consequences of monetary union among countries that face varying degrees of financial market distortions and whose firms compete in customer markets. In the absence of devaluation, firms experiencing an adverse liquidity shock in financially weak countries (the periphery) have an incentive to raise prices—and sacrifice their market share in order to overcome a temporary liquidity squeeze—while firms in countries with greater financial capacity (the core) lower prices, undercutting their financially constrained foreign competitors and gaining their market share. Because the latter do not internalize the effects of a price cut on union-wide aggregate demand, a monetary union among countries with heterogeneous financial capacity can create a tendency toward internal devaluation for core countries, leading to chronic current account deficits in the periphery. While a risk-sharing arrangement between the core and the periphery can undo the distortion brought about by the currency union, such an arrangement involves large wealth transfers from the core to the periphery. Depending on the degree of pecuniary externality not internalized by the predatory pricing strategies of individual firms, unilateral fiscal devaluation carried out by the peripheral countries can improve joint welfare of the union.