Essays in International Macroeconomics

Abstract

What are the conditions for a well-functioning currency union? Since the 1960s', there has been a long stream of literature dedicated to this question. Through studying the historical fixed exchange rate regime of the Gold Standard (chapter 2) and the modern day euro area (chapters 3 and 4), this thesis aims to add to the understanding of the economics of currency unions.<br /> Chapter 2 "When Do Fixed Exchange Rate Work? Evidence from the Gold Standard" examines external adjustments within a currency union. In particular, my co-author Felix Ward and I look at the historical circumstances of a fixed exchange rate regime that worked smoothly – the 1880-1913 Gold Standard. External adjustment under the Gold Standard was associated with few if any, output costs. How did countries on the Gold Standard equilibrate so smoothly despite inflexible exchange rates that were pegged to gold? To answer this question, we build and estimate an open economy model of the Gold Standard. This allows us to quantitatively assess the relative importance of three prominent channels of external adjustment: flexible prices, international migration, and monetary policy. Our first finding is that the output resilience of Gold Standard members was primarily a consequence of flexible prices. When hit by a shock, quickly adjusting prices induced import- and export responses that stabilized output. Neither restrictions on migration, nor the elimination of countercyclical monetary policy would have given rise to substantially higher output-volatility. Our second finding is that price flexibility was predicated on a historical contingency: namely large primary sectors, whose flexibly priced products dominated the export booms that stabilized output during major external adjustments.<br /> Chapter 3 "Sovereign Default Risk and the Role of International Transfers" asks what is the impact of interregional risk sharing arrangements when countries are afflicted with sovereign default risk. This is of particular interest in the setup of currency unions, where countries give up the exchange rate as a tool for business cycle stabilization. I introduce a sovereign default model in which regional sovereign default risk affects private sector financing costs and the linkage between public and private sector financing costs can exacerbate economic downturns. In this context, the benefit of international risk sharing comes in two dimensions. First, it helps to smooth consumption – the traditional channel of insurance. More importantly, by ameliorating large recessions, international risk sharing reduces the asymmetric impact of productivity shocks and raises average output level. Quantitative analysis shows that most of the welfare benefits that are obtainable from the optimal risk sharing arrangement can be reaped by a standby facility that is easy to implement. This finding is of policy relevance because whenever interregional risk sharing schemes are discussed between sovereign nation states, the willingness to part with fiscal autonomy is often severely limited.<br /> In Chapter 4 "Sovereign Risk Spillover and Monetary Policy in a Currency Union", I investigate the pass-through of sovereign default risk to the private sector financing condition from a different angle. In particular, I use a two-region currency union model to examine how the spillover affects shock propagation and optimal monetary policy. On the one hand, an increase in a region's sovereign risk premium raises the regional private sector credit spread, depresses inflation and tax revenue and further worsens the fiscal position. On the other hand, it also triggers changes in the policy interest rate. The net impact depends on the maturity of the government debt. When calibrated to the euro area and taken into account the average long maturity of government debt, the impact of the sovereign risk spillover on shock propagation is negligible. This is also reflected in optimal monetary policy. For the euro area, optimal monetary policy is well approximated by a simple target criterion that describes the optimal relation between output and inflation as derived from a basic New Keynesian model without sovereign risk and credit spreads. This continues to be the case even when there are cross-regional differences in their exposure to sovereign default risks. If government debts are short-term, however, the spillover considerably affects shock transmission and optimal monetary policy requires a stronger immediate shock-response.