The fragility of incomplete monetary unions
12 important questions on The fragility of incomplete monetary unions
How to correct a current account deficit?
2. Devalue currency, more competitive exports
Why is the fixed exchange rate system very fragile?
- the equilibria depend on the fact that the CB has limited stock of international reserves
How can countries deal with the fragility of the fixed exchange rate?
2. allow for more flexibility of exchange rates
> Many countries resist to choose, looked for a way out: possible due to re-imposing capital controls. But as integration increases, the need to open up capital markets becomes more intense, increasing the fragility.
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How can the credibility of fixed exchange rate regimes be enhanced? How does a currency board relate to this?
1. the country fixes its rate to an anchor currency, promises convertibility at a fixed rate
2. the country backs the issue of the domestic currency by holdings of the anchor currency
3. there is a legal commitment to maintain the fixed exchange rate
How does a government benefit from defaulting on repaying debt and what factors make defaulting more beneficial?
1. the higher the initial debt level, the higher the benefit
2. the efficiency of the tax system, the lower efficiency, the higher the benefit
3. the bigger the size of external debt, the higher the benefit
What happens when investors anticipate a default?
What is the cost of defaulting?
What kind of shocks are there, how do they affect a government's decision to default?
large: cost < benefit of default
intermediate: both are possible: what investors expect will happen (self-fulfilling)
How can the fragility of the incomplete MU be reduced?
2. entrust the role of LOLR to ECB
3. condolidate national debt into one common debt (i.e. incomplete MU > complete MU)
How might an incomplete MU stuck in a bad equilibrium cause a banking crisis (after defaulting)?
2. domestic banks are caught up in a funding problem: domestic liquidity dries up (MS declines) making it hard for domestic banks to roll-over their deposits except by paying prohibitive interest rates. Sovereign debt crisis > domestic banking crisis (even with sound banks)
! Banking union might allow to spread the cost of a banking crisis (difficult)
How do automatic stabilizers relate to liquidity and solvency crisis?
Name two types of incomplete MUs and explain how they relate
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