1. Financial Heterogeneity and Monetary Union
S. Gilchrist1 R. Schoenle2 J. Sim3 E. ZakrajĖsek3
1
Boston University and NBER
2
Brandeis University
3
Federal Reserve Board
Barcelona GSE, ADEMU
June 8, 2017
DISCLAIMER: The views expressed are solely the responsibility of the authors and should not be interpreted as reļ¬ecting the views of the Board of Governors
of the Federal Reserve System or of anyone else associated with the Federal Reserve System.
2. INTRODUCTION
Eurozone Crisis (2008ā2013)
Classic balance-of-payment crisis:
ā® The mix of overvalued RERs and cheap credit fueled by economic optimism
led to over- and mal-investment
ā® With the Global Financial Crisis came a sudden stop
Resolution of the crisis:
ā® Realignment of overvalued RERs
ā® The mix of deļ¬ation in the āperipheryā and reļ¬ation in the ācoreā
ā® Surprisingly hard to achieveāwhy?
3. INTRODUCTION LESSONS FROM THE U.S. EXPERIENCE
āMissing Deļ¬ationā in the U.S.
New empirical evidence on the ļ¬rmsās price-setting behavior during the
2007ā09 crisis:
(Gilchrist & ZakrajĖsek [2016]; Gilchrist, Schoenle, Sim & ZakrajĖsek [2017])
ā® Firms with strong balance sheets cut prices
ā® Firms with weak balance sheets raised prices
Similar patterns documented for the euro area
(Montero & Urtasun [2014]; Antoun de Almeida [2015])
Theory:
ā® GSSZ develop a DSGE model that can replicate such price and output
patterns in periods of ļ¬nancial distress
ā® Emphasizes the interaction between ļ¬nancial market frictions and ļ¬rmsā
pricing decisions in customer markets
(Bils [1989]; Chevalier & Scharfstein [1996])
4. INTRODUCTION LESSONS FROM THE U.S. EXPERIENCE
U.S. PPI Inļ¬ation
Liquidity constrained vs. unconstrained ļ¬rms
2005 2006 2007 2008 2009 2010 2011 2012
-25
-20
-15
-10
-5
0
5
10
Percentage points
Low liquidity firms
High liquidity firms
3-month moving average, annualized
NOTE: Weighted average monthly inļ¬ation relative to industry (2-digit NAICS) PPI inļ¬ation.
SOURCE: Gilchrist, Schoenle, Sim & ZakrajĖsek [2017]
5. INTRODUCTION LESSONS FROM THE U.S. EXPERIENCE
Key Takeaways
Internal liquidity positions played an important role in shaping U.S. ļ¬rmsā
price-setting behavior during the ļ¬nancial crisis.
Disruption in ļ¬nancial markets in 2008 forced ļ¬rms with limited ļ¬nancial
capacity to signiļ¬cantly increase their prices, whereas their unconstrained
counterparts cut prices during the concomitant economic downturn.
Industry-level data suggests this is a more general phenomenon in
response to ļ¬nancial market disruptions.
6. INTRODUCTION EVIDENCE FROM THE EURO AREA
Euro Area Inļ¬ation and Economic Activity
1992ā2007 2008ā2013
Average (%) Core GIIPS Core GIIPS
Inļ¬ation 1.74 4.02 1.49 0.55
Output gap ā0.07 0.81 ā0.73 ā2.98
Unemployment gap 0.46 ā0.60 ā0.09 1.27
Core = AUT, DEU, BEL, FIN, FRA, NLD; GIIPS = GRC, IRL, ITA, ESP, PRT
SOURCE: AMECO database.
Is lack of disinļ¬ationary pressures in the periphery during the crisis
related to ļ¬nancial strains?
7. INTRODUCTION EVIDENCE FROM THE EURO AREA
Financial Conditions and Inļ¬ation Dynamics
Panel-versions of the price and wage Phillips Curves:
ā® Prices: accelerationist
Ļit = Ī±i + Ī²Ļi,tā1 + Ī»(uit ā ĀÆuit ) + ĻāVATit + Ļ1[i ā e] + Ē«it ;
ā® Prices: hybrid New Keynesian
Ļit = Ī±i + Ī²f Et Ļi,t+1 + Ī²bĻi,tā1 + Ī»mcit + ĻāVATit + Ļ1[i ā e] + Ē«it ,
ā® Wages: accelerationist
āwit = Ī±i + Ī²Ļi,tā1 + Ī»(uit ā ĀÆuit ) + ĻāĖzit + Ļ1[i ā e] + Ē«it ;
Data
ā® Countries: AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT
ā® Estimation period: 1970ā2007
Are the PC prediction errors during the crisis related to the degree of
ļ¬nancial strains across countries?
9. INTRODUCTION EVIDENCE FROM THE EURO AREA
Financial Conditions in the Euro Area
Sovereign (5-year) CDS spreads
2008 2010 2012 2014
Percentage points (log scale)
Italy
Greece
Portugal
Spain
Ireland
Mar./Oct.
Periphery countries
0
0.5
2
10
50
200
2008 2010 2012 2014
Percentage points (log scale)
Austria
Belgium
France
Germany
Netherlands
Finland
Mar./Oct.
Core countries
0
0.1
0.5
1
2
4
SOURCE: Markit.
10. INTRODUCTION EVIDENCE FROM THE EURO AREA
Sovereign Distress and Business Credit Conditions
Euro area, 2008ā2013
Explanatory Variables (1) (2)
ln CDSi,tā1 0.568 0.832
[0.406, 0.731] [0.493, 1.180]
Adj. R2
0.200 0.210
Time ļ¬xed effects N Y
NOTE: Bootstrapped 95% conļ¬dence intervals in brackets.
11. INTRODUCTION EVIDENCE FROM THE EURO AREA
Financial Conditions and PC Prediction Errors
Without time ļ¬xed effects, 2008ā2013
Explanatory Variable
Speciļ¬cation ln CDSi,tā1 ln CDSi,tā1 Ć 1[i ā P] R2
(1) Prices (homogeneous) 0.043 0.601 0.198
[ā0.139, 0.227] [0.218, 0.985]
(2) Prices (heterogeneous) 0.204 0.593 0.258
[0.028, 0.372] [0.156, 1.030]
(3) Hybrid NK 0.028 0.299 0.110
[ā0.100, 0.156] [0.022, 0.577]
(4) Wages (homogeneous) ā0.008 ā0.776 0.254
[ā0.266, 0.251] [ā1.425, 0.100]
(5) Wages (heterogeneous) 0.085 ā2.075 0.425
[ā0.190, 0.360] [ā3.082, ā1.069]
NOTE: Bootstrapped 95% conļ¬dence intervals in brackets.
12. INTRODUCTION EVIDENCE FROM THE EURO AREA
Financial Conditions and PC Prediction Errors
With time ļ¬xed effects, 2008ā2013
Explanatory Variable
Speciļ¬cation ln CDSi,tā1 ln CDSi,tā1 Ć 1[i ā P] R2
(1) Prices (homogeneous) 0.044 0.453 0.329
[ā0.239, 0.327] [0.092, 0.814]
(2) Prices (heterogeneous) 0.684 0.275 0.419
[0.369, 0.999] [0.031, 0.519]
(3) Hybrid NK 0.125 0.200 0.205
[ā0.051, 0.301] [ā0.031, 0.410]
(4) Wages (homogeneous) ā1.364 ā0.495 0.352
[ā2.221, ā0.506] [ā1.359, 0.369]
(5) Wages (heterogeneous) ā2.196 ā1.469 0.542
[ā2.731, ā1.661] [ā2.550, ā0.389]
NOTE: Bootstrapped 95% conļ¬dence intervals in brackets.
13. INTRODUCTION EVIDENCE FROM THE EURO AREA
Economic Signiļ¬cance of Financial Factors
Euro area periphery, 2008ā2013
2008 2009 2010 2011 2012 2013
-16
-8
0
8
16
Percentage points
Actual price inflation
Effect of financial conditions
Actual wage inflation
Effect of financial conditions
Price and wage inflation
Annual
2008 2009 2010 2011 2012 2013
-28
-14
0
14
28
Percent
Prices
Wages
Counterfactual prices and wages
Annual
NOTE: In deviations from 2008 levels.
14. INTRODUCTION EVIDENCE FROM THE EURO AREA
Price Markups
Euro area, 2000ā2015
-10
-5
0
5
10
15
20
25
Percent
Annual
Periphery countries
2000 2005 2010 2015
-10
-5
0
5
10
15
20
25
Percent
Annual
Core countries
2000 2005 2010 2015
NOTE: The markup is equal to minus (100 times) the log or real unit labor costs (2008 = 1).
SOURCE: AMECO database.
15. INTRODUCTION EVIDENCE FROM THE EURO AREA
Financial Conditions and Price Markups
Euro area, 2008ā2013
Explanatory Variable
Speciļ¬cation ln CDSi,tā1 ln CDSi,tā1 Ć 1[i ā P] R2
A. Aggregate
(1) Without time ļ¬xed effects ā0.205 1.378 0.256
[ā0.944, 0.534] [0.557, 2.220]
(2) With time ļ¬xed effects ā0.312 1.148 0.681
[ā0.528, ā0.095] [0.926, 1.372]
B. Sectoral
(3) Without time ļ¬xed effects ā0.442 2.556 0.057
[ā2.135, 1.252] [0.913, 4.198]
(4) With time ļ¬xed effects ā0.331 1.974 0.152
[ā1.915, 1.254] [1.244, 2.704]
NOTE: Bootstrapped 95% conļ¬dence intervals in brackets.
16. MODEL INTRODUCTION
Financial Heterogeneity as a Propagation Mechanism
This paper:
ā® Extend GSSZ [2015] to a two-country setting (ācoreā and āperipheryā)
ā® Study the consequences of forming a monetary union among countries with
heterogeneous ļ¬nancial capacities
Implications:
ā® During a ļ¬nancial crisis in the periphery, core has an incentive to lower
prices to gain market share at home and abroad
ā® Firms in the periphery are forced to raise prices to maintain current
cashļ¬ows, thereby sacriļ¬cing future market shares
ā® RER appreciating for periphery rather than for core creates a feedback loop
that reinforces liquidity crisis in the periphery
17. MODEL INTRODUCTION
Policy Options
Fiscal Union:
ā® Trading state-contingent bonds among heterogeneous countries
ā® Highly beneļ¬cial to the periphery but requires large transfers from the core
Fiscal Devaluation:
ā® Certain mixes of ļ¬scal instruments replicate the devaluation
ā® When can a unilateral ļ¬scal devaluation by the periphery be beneļ¬cial to the
core?
18. MODEL ENVIRONMENT
Preferences
Two countries: home (h = periphery) and foreign (f = core)
Continuum of households in each country: j ā Nc ā” [0, 1]
Two types of goods:
home goods (h): c
j
i,h,t , i ā Nh ā” [0, 1]
foreign goods (f ): c
j
i,f,t , i ā Nf ā” [1, 2]
Preferences of household j in the home country:
Et
ā
ā
s=0
Ī“s
U(x
j
t+s, h
j
t+s)
ā® labor (h) is immobile
19. MODEL ENVIRONMENT
āDeep Habitsā
Ravn, Schmitt-Grohe & Uribe [2006]
Consumption/habit aggregator:
x
j
t = ā
k=h,f
Īk
Nk
c
j
i,k,t /sĪø
i,k,tā1
1ā1/Ī·
di
1ā1/Ē«
1ā1/Ī·
1/(1ā1/Ē«)
ā® Ī· > 0 is the elasticity of substitution within a type of goods
ā® Ē« > 0 is the elasticity of substitution between the two types of goods
ā® 0 < Īk < 1 governs the degree of home bias in consumption
ā® si,k,t = good-speciļ¬c stock of habit
ā® Īø < 0 governs the strength of ādeepā habits
Law of motion for (external) deep habits:
si,k,t = Ļsi,k,tā1 + (1 ā Ļ)
1
0
c
j
i,k,t dj; k = h, f
ā® āKeeping up with the Jonesesā at the good level
20. MODEL ENVIRONMENT
Technology
Continuum of monopolistically competitive ļ¬rms producing variety of
differentiated goods of type h and type f.
ā® Labor is the only input
Production function of home country ļ¬rms:
yit = ci,h,t + cā
i,h,t =
At
ait
hit
Ī±
ā Ļ; i ā Nh (0 < Ī± ā¤ 1)
ā® At = persistent aggregate technology shock
ā® ait = i.i.d. idiosyncratic cost shock w/ log ait ā¼ N(ā0.5Ļ2, Ļ2)
ā® Ļ = ļ¬xed costs ā ļ¬rms can incur operating losses
ā® Homogeneous operating costs: Ļ = Ļā
21. MODEL FRICTIONS
Liquidity Risk
First half of period t:
ā® Collect information about the aggregate state of the economy
ā® Post prices, take orders from customers, and plan production based on
expected marginal cost
Second half of period t:
ā® Idiosyncratic uncertainty is resolved, and ļ¬rms realize actual marginal cost
ā® Hire labor to fulļ¬ll agreed-upon orders and produce output
End of period t:
ā® Pay out all operating proļ¬ts as dividends
ā® In the case of operating losses, the ļ¬rm must issue new shares
22. MODEL FRICTIONS
Financial Frictions
Costly external equity ļ¬nancing:
(Myers & Majluf [1984]; Gomes [2001]; Stein [2003])
ā® New shares sold at a discount because of asymmetric information
ā® 1 e claim raises only (1 ā Ļ) e of funds (0 < Ļ < 1)
Heterogeneity in ļ¬nancial capacity: Ļā < Ļ
No cross-border ownership of ļ¬rms.
(Obstfeld & Rogoff [2000])
23. MODEL FRICTIONS
āBeggar Thy Neighborā at the Micro Level
Deep habits make investment in market share proļ¬table:
ā® Investment takes the form of low markups, which exposes ļ¬rms to liquidity
risk
ā® Optimal pricing strategy strikes the right balance
Price war:
ā® Liquidity crisis in the periphery is a good time for ļ¬rms from the core to steal
market share by undercutting their competitorsā prices
āMr. Marchionne and other auto executives accuse Volkswagen of
exploiting the crisis to gain market share by offering aggressive
discounts. āItās a bloodbath of pricing and itās a bloodbath on
margins,ā he said.ā
ā The New York Times, July 25, 2012
24. MODEL FRICTIONS
āBeggar Thy Neighborā at the Micro Level
Deep habits make investment in market share proļ¬table:
ā® Investment takes the form of low markups, which exposes ļ¬rms to liquidity
risk
ā® Optimal pricing strategy strikes the right balance
Price war:
ā® Liquidity crisis in the periphery is a good time for ļ¬rms from the core to steal
market share by undercutting their competitorsā prices
āMr. Marchionne and other auto executives accuse Volkswagen of
exploiting the crisis to gain market share by offering aggressive
discounts. āItās a bloodbath of pricing and itās a bloodbath on
margins,ā he said.ā
ā The New York Times, July 25, 2012
25. MODEL FRICTIONS
Nominal Rigidities
Quadratic costs of adjusting nominal prices:
(Rotemberg [1982]; Erceg, Henderson & Levin [2000])
Ī³p
2
Pi,h,t
Pi,h,tā1
ā 1
2
ct +
Ī³ā
p
2
Qt Pā
t
Pt
Pā
i,h,t
Pā
i,h,tā1
ā 1
2
cā
t ; (Ī³p, Ī³ā
p > 0)
ā® Qt = nominal exchange rate (home/foreign currency)
ā® Consumer price index (CPI) in the home country:
Pt ā” ā
k=h,f
Īk P1āĪµ
k,t
1
1āĪµ
, where Pk,t ā”
Nk
Pi,k,t
1āĪ·
di
1
1āĪ·
; k = h, f
Pricing to market: law of one price does not apply
(Fabiani, Loupias, Martins & Sabbatini [2007])
27. MODEL FRICTIONS
Optimal Pricing
Assume ļ¬exible prices and no customer markets.
When Ī± = 1, optimal pricing (home market) ā
pi,h,t ph,t =
Ī·
Ī· ā 1
accounting markup
Ć
EA
t [Ī¾it ait ]
EA
t [Ī¾it ]
economic markup
Ć
Wt /Pt
At
real marginal cost
Financial frictions ā
EA
t [Ī¾it ] > 1
EA
t [Ī¾it ait ]
EA
t [Ī¾it ]
= 1 + Cov[Ī¾it ait ] ā„ 1
28. MODEL FRICTIONS
Optimal Pricing (cont.)
Bring back customer markets (still ļ¬exible prices!)
Growth-adjusted, compounded discount rate:
ĖĪ²t,s ā” ms,s+1
sh,s+1/sh,s ā Ļ
1 ā Ļ
Ć
sāt
ā
j=1
Ļ + Ļ
sh,t+j /sh,t+jā1 ā Ļ
1 ā Ļ
mt+jā1,t+j
Optimal pricing ā
pi,h,t ph,t =
Ī·
Ī· ā 1
EA
t [Ī¾it ait ]
EA
t [Ī¾it ]
Wt /Pt
At
ā
Ļ
Ī· ā 1
Et
ā
ā
s=t+1
ĖĪ²t,s
EA
s[Ī¾i,s]
EA
t [Ī¾i,t ]
ph,s ā
Ws/Ps
As
29. MODEL Calibration
Financial Shocks
Temporary but persistent increase in the cost of external ļ¬nance:
Ļt = ĀÆĻ Ć ft , log ft = 0.90 Ć log ftā1 + Ē«f,t , Ē«f,t ā¼ N(ā0.5Ļ2
f , Ļ2
f )
Asymmetric shock ā affects the home country only.
Size of the shock: Ļt ā 2 ĀÆĻ upon impact
30. MODEL Calibration
Calibration Summary
Key Model Parameters Value
Preferences & Technology
strength of deep habits (Īø) ā0.86
persistence of deep habits (Ļ) 0.85
elasticity of substitution b/w and w/i goods (Ī·, Ē«) (2.00,1.50)
ļ¬xed operating costs (Ļ, Ļā) (0.10,0.10)
idiosyncratic volatility (Ļ) 0.15
Nominal Rigidities
price adjustment costs (Ī³p) 10.0
wage adjustment costs (Ī³w ) 30.0
Financial Frictions
equity dilution costs ( ĀÆĻ, ĀÆĻā), EA
t [Ī¾it ] = 1.16 (0.20,0.02)
31. MODEL SIMULATIONS
Implications of an Asymmetric Financial Shock
Under ļ¬oating exchange rates (Ļ = 0.20, Ļā = 0.02)
-1.0
-0.5
0.0
0.5
1.0
1.5
pct.
Home
Foreign
(a) Real GDP
0 8 16 24 32
-0.8
-0.4
0.0
0.4
0.8
pps.
(b) Consumption
0 8 16 24 32
-2
-1
0
1
2
pps.
(c) Hours worked
0 8 16 24 32
-1.5
0.0
1.5
3.0
4.5
6.0
7.5
pps.
(d) Interest rate
0 8 16 24 32
-1
0
1
2
3
4
5
pct.
Real
Nominal
(e) Exchange rate
0 8 16 24 32
-0.5
0.0
0.5
1.0
1.5
pps.
(f) Inflation
0 8 16 24 32
-1.6
-0.8
0.0
0.8
1.6
pct.
(g) Exports
0 8 16 24 32
-1.0
-0.5
0.0
0.5
1.0
pct. of GDP
(h) Current account
0 8 16 24 32
NOTE: Exchange rates are expressed as home currency relative to foreign currency.
32. MODEL SIMULATIONS
Implications of an Asymmetric Financial Shock
In a monetary union (Ļ = 0.20, Ļā = 0.02)
-1.0
-0.5
0.0
0.5
1.0
1.5
pct.
Home
Foreign
(a) Real GDP
0 8 16 24 32
-0.8
-0.4
0.0
0.4
0.8
pps.
(b) Consumption
0 8 16 24 32
-2
-1
0
1
2
pps.
(c) Hours worked
0 8 16 24 32
-1.5
0.0
1.5
3.0
4.5
6.0
7.5
pps.
(d) Interest rate
0 8 16 24 32
-1
0
1
2
3
4
5
pct.
Real
Nominal
(e) Exchange rate
0 8 16 24 32
-0.5
0.0
0.5
1.0
1.5
pps.
(f) Inflation
0 8 16 24 32
-1.6
-0.8
0.0
0.8
1.6
pct.
(g) Exports
0 8 16 24 32
-1.0
-0.5
0.0
0.5
1.0
pct. of GDP
(h) Current account
0 8 16 24 32
NOTE: Exchange rates are expressed as home currency relative to foreign currency.
34. MODEL SIMULATIONS
Relative Import Shares
Euro area periphery and core, 2008ā2015
0
50
100
150
200
2008 2010 2012 2014
80
90
100
110
120
Index(2008=100) Index(2008=100)
By broad economic categories
Annual
BEC-1 (RHS) BEC-2 (RHS) BEC-3 (LHS)
BEC-4 (RHS) BEC-5 (RHS) BEC-6 (RHS)
BEC-7 (LHS)
2008 2010 2012 2014
85
90
95
100
105
Index(2008=100)
Average
Median
Trade-weighted aggregates
Annual
35. MODEL SIMULATIONS
Financial Heterogeneity and Monetary Union
Alternative calibration: Ļ = Ļā = 0.20
All other parameters are kept at their baseline values.
Financial shocks in both core and periphery.
37. POLICY IMPLICATIONS
Welfare Consequences of a Monetary Union
Heterogeneous ļ¬nancial capacity (Ļ = 0.20, Ļā = 0.02)
Welfare
Monetary Union Flexible FX CE (%)
Home country ā259.23 ā254.16 2.53
Foreign country ā254.05 ā254.26 ā0.11
Joint ā513.28 ā508.42 .
40. POLICY IMPLICATIONS
Monetary Union with Complete Risk Sharing
Asymmetric ļ¬nancial shock (Ļ = 0.20, Ļā = 0.02)
-1.0
-0.5
0.0
0.5
1.0
1.5
pct.
Home, baseline
Foreign, baseline
Home, risk sharing
Foreign, risk sharing
(a) Real GDP
0 8 16 24 32
-0.6
-0.3
0.0
0.3
0.6
pct.
(b) Consumption
0 8 16 24 32
-1.0
-0.5
0.0
0.5
pct.
Baseline
Risk sharing
(c) Real exchange rate
0 8 16 24 32
-1.0
-0.5
0.0
0.5
1.0
pct. of GDP
Home
Foreign
(d) Contingent transfer
0 8 16 24 32
NOTE: Exchange rates are expressed as home currency relative to foreign currency.
41. POLICY IMPLICATIONS
Welfare Consequences of a Fiscal Union
Heterogeneous ļ¬nancial capacity (Ļ = 0.20, Ļā = 0.02)
Welfare in a Monetary Union
w/o Risk Sharing w/ Risk Sharing CE (%)
A. Calibration: Īø = ā0.86, Ļ = 0.85, Ļā = 1.0 Ć Ļ
Home country ā259.23 ā257.61 0.79
Foreign country ā254.05 ā253.15 0.45
Joint ā513.28 ā510.76 .
B. Calibration: Īø = ā0.95, Ļ = 0.95, Ļā = 1.0 Ć Ļ
Home country ā283.64 ā279.86 1.71
Foreign country ā278.47 ā274.84 1.66
Joint ā562.11 ā554.80 .
C. Calibration: Īø = ā0.86, Ļ = 0.85, Ļā = 0.9 Ć Ļ
Home country ā261.00 ā254.69 3.13
Foreign country ā248.73 ā249.81 ā0.56
Joint ā509.73 ā504.50 .
42. POLICY IMPLICATIONS
Theory of Fiscal Devaluation
Adao, Correia & Teles [2009]; Farhi, Gopinath & Itskhoki [2014]
Some EU countries have considered the idea of swapping VAT and
payroll subsidies:
ā® VAT is a discriminatory tax on imported goods.
ā® For revenue-neutrality, payroll subsidy to domestic ļ¬rms.
Germany:
ā® Raised VAT (from 16% to 19%) on January 2007
ā® Lowered corporate income tax rate (from 38.7% to 29.8%) on July 2007
(effective January 2008).
43. POLICY IMPLICATIONS
Implementable Plan
We consider a simple VAT-payroll subsidy swap rule
(VAT (ĻV
t ) + payroll subsidy (ĻP
t ))
FD rules that are linear in the resource gap of the home country and
revenue neutral:
ĻV
t =
āt
1 + āt
āt = āĪ±FD
Ć log
yt
ĀÆy
(Ī±FD
> 0)
ĻP
t = ĻV
t Ć (ph,t ch,t + pf,t cf,t )
ā® Foreign country does not retaliate
ā® Home ļ¬rms are not subject to the VAT in the foreign country
Is there a region for Ī±FD
that is mutually beneļ¬cial to both home and
foreign countries?
44. POLICY IMPLICATIONS
Welfare Implications of Fiscal Devaluations
Monetary union (Ļ = 0.20, Ļā = 0.02)
0
2
4
6
0 10 20 30
Home
Foreign
FD
Ī±
(a) Deep habits:Īø = ā0.3 and Ļ = 0.3
Changeinwelfare
0
2
4
6
0 10 20 30FD
Ī±
(b) Deep habits:Īø = ā0.86 and Ļ = 0.85
Changeinwelfare
0
2
4
6
0 10 20 30FD
Ī±
(c) Deep habits: Īø = ā0.95 and Ļ = 0.95
Changeinwelfare
45. POLICY IMPLICATIONS
Welfare Implications of Fiscal Devaluations
The role of ļ¬nancial frictions
0 10 20 30
0
2
4
6
Change in welfare
( ) FD: The effect of fixed cost
FD
Ī±
0 10 20 30
0
2
4
6
Change in welfare
( ) FD: The effect of issuance cost
FD
Ī±
46. CONCLUSION
Summary
With customer markets, differences in ļ¬nancial capacity across countries
imply a strong ampliļ¬cation mechanism.
Monetary union impedes adjustment of RERs and exacerbates the
downturn in response to an adverse ļ¬nancial shock.
Unilateral ļ¬scal devaluation by periphery may be welfare improving for
both periphery and core.