The aim of this paper is to study how financial structures and monetary policy regimes (including exchange rate regimes) affect the pattern of business cycle correlation across countries. More specifically, I propose a unitary framework in which international business cycle co-movements are explained jointly by the differences between the financial systems and by the monetary policy regime adopted by the countries concerned.
The European Union is a prime example where my analysis is likely to be relevant. The 12 countries of the euro area have adopted a single currency but are still characterized by different financial structures, as a result of history, legal frameworks, collective preferences and politics. Financial regulations, legislation and bank supervisory policies of these countries have not been unified but remain largely under national control — though pressures towards harmonization and the adoption of common standards, partly as a result of the single currency, are mounting. Of the remaining EU members, many (including several new entrants from Central and Eastern Europe) will adopt the euro before or around the end of this decade, and also in preparation for that are introducing financial market reforms. This process of currency unification and financial reform taking place at continental level provides an ideal testing ground for my theory. Examining the implications of this for business cycles is clearly important for many reasons, e.g. to determine the optimal monetary policy and to study the welfare properties of the currency area.
The approach I propose helps to rationalize, within a common framework, two separate bodies of recent empirical findings. First, the empirical literature on the transmission mechanism has highlighted the central role of financial and banking structures, particularly in Europe, in shaping the strength and the timing of the effects of monetary policy on the economy. Moreover, an increase in the cyclical co-movement of the euro area countries in recent years has been reported. On both aspects, a short survey of recent papers is provided in the next section. Against this background, my theoretical model predicts that a lesser financial diversity increases the cyclical correlation for any given monetary regime, whereas moving from independent monetary policies to a currency peg or even more to a common currency tends to increase it, for any given degree of financial distance. As I show, a model embodying these features explains well the empirical patterns of business cycle correlations, and changes thereof, observed recently among the main European countries.
The argument proceeds in three steps. First, I lay out a laboratory economy with two regions, where the effects of financial diversity and of alternative monetary regimes on business cycle comovements can be analyzed within a unified theoretical framework. The model economy is a stochastic dynamic general equilibrium with optimizing agents, characterized by adjustment costs on prices in an imperfectly competitive framework, by imperfect financial integration and different degrees of financial fragility. The presence of sticky prices is essential to analyze the effects of endogenous monetary policy response. Imperfect financial integration means here that households do not have access to a complete set of state contingent international securities. Financial frictions are introduced by postulating borrowing constraints on investment due to asymmetric information between borrowers and lenders. Financial diversity is modelled in terms of asymmetric costs of bankruptcy and riskiness of investment projects. The external finance premium is proxied by the spread between bank lending rates (or corporate bond rates) over money market rates; the calibration is made with reference to the four largest euro area countries (Germany, France, Italy and Spain), with the UK and the US used as controls. The external finance premium determines the tightness of the borrowing limit and is related to the conditions (i.e. the value) of the collateral in the economy. In this environment, the sensitivity of the borrowing limit to the collateral conditions is the key determinant of the link between financial fragility and the business cycle.
Second, the model is subject to monetary policy and productivity shocks calibrated using euro area data. I consider three monetary policy regimes. The first is a currency area in which monetary policy targets area-wide CPI inflation. In the second the two countries follow independent monetary policies, each targeting its own domestic CPI inflation. In the third, the home country targets its domestic CPI inflation and the foreign one unilaterally and credibly pegs its exchange rate. In all three regimes, different elasticities of credit availability to collateral conditions between the two countries produce different business cycle responses to shocks, hence different degrees of persistence and volatility in real output and the other main macro variables. The differences in financial structures also generates differences in the return to capital investment which induces agents to relocate physical capital and investment projects abroad. Capital flows occur towards countries characterized by more profitable investment conditions i.e. higher sensitivity of credit availability to leverage ratio. Due to both of these channels, lower business cycle co-movements arise as a result of higher financial distance.
The comparison across monetary regimes shows that, in the presence of financial differences, all macro variables are more synchronized in a currency area than under an independent policy regime. In both regimes, the different sensitivity of the borrowing conditions to collateral gives rise to different sensitivity of business cycle fluctuations to shocks. Under independent policies, however, the endogenous response of the national monetary policy to such differences in fluctuations tends to amplify the non-synchronism of cycles. Under the unilateral peg, the business cycle co-movements are very close to the ones arising under the currency area regime - the difference generated by the fact that in this regime the monetary policy target is the home country’s inflation rate, not the one of the area, turns out to be small.
The third step is to show that the model predictions broadly correspond to the data evidence. I do this for the four largest euro area countries, using the UK and the US as control cases. To do this, cross-country correlations of output, consumption, investment and employment generated by the model are compared with the empirical counterparts. The independent policies and the currency area regimes in the model are compared, respectively, with the pre-EMU and the post-EMU periods. The model successfully replicates the broad patterns of empirical correlations.
The paper is organized as follows. Section 2 reviews the empirical literature on the transmission mechanism in the euro area and documents the presence of differences in the financial markets. Section 3 presents the model, which is then calibrated in section 4. Section 5 shows the dynamic properties of the model under the different financial and monetary regimes. Finally, section 6 compares the model results with the data, and section 7 concludes. Tables and graphs are reported at the end of the paper.
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