Abstract
The pronounced increase in external imbalances in the European Economic and Monetary Union (EMU) during the years running up to 2008 is traditionally explained by financial integration through the common currency. This paper examines in a one-good, two-country overlapping generations’ model, with production, capital accumulation and public debt, the effects of financial integration on the net foreign asset positions of initially low-interest and high-interest rate EMU countries. We find that a lower savings rate and government expenditure quota, together with a higher capital production share in the latter can in fact be transformed into the observed external imbalances when interest rates converge.
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Notes
In addition to financial integration Chen et al. (2012, pp. 6–7) count among “traditional explanations for the rise of euro area imbalances” “expected growth”, “over-optimism” and “excessive real appreciation”. Moreover, they point out that “new stylized facts” concerning the euro area imbalances and the rest of the world are also important in fully understanding intra-EMU external imbalances.
Giavazzi and Spaventa (2010, p. 7) argue similarly.
Compensation costs include direct pay, social insurance expenditures and labor-related taxes.
In order to save on space we present in the following only southern intertemporal equilibrium equations. Northern equilibrium equations are analogous.
Clearly, the relatively lower southern savings ratio (as percent of disposable income) cannot be attributed only to a higher time preference rate. However, the lower southern income tax rates suggest that higher southern time preference are indeed the driving factor for periphery’s lower savings ratio.
This is tantamount to assuming that the labor compensation cost differentials are not solely due to differences in output prices and national fiscal instruments.
The assumption of flat (gross) wage taxes clearly clashes with European tax code reality. However, since this paper does not focus on taxation, for the sake of analytical simplicity, a constant wage tax rate is assumed.
To save space analysis of the existence and dynamic stability of steady states is performed only for South. Northern existence and stability analysis is analogous.
See previous footnote.
Chen et al. (2012) point out that periphery’s current account deficits after euro launch and before 2008 while mainly financed by the EMU core were due to imports from the rest of the world and not from the EMU core. Moreover, core’s (in particular Germany’s) merchandise exports went mainly to emerging countries like China. Thus, empirically speaking, it is not premature to assume that in our two-country modeling framework there is no trade in goods and services.
Lin (1994, p. 97) shows that this definition of the real exchange rate is consistent with those in standard textbooks as e.g. in Dornbusch and Fischer (1990, pp. 184–185) where the real exchange rate e is defined as: e = EP/P * with E standing for the nominal exchange rate, and P and P * being the domestic and foreign price level, respectively.
Both capital production shares and time preference factors are calibrated such that a 1987-1997 average core (periphery) yearly real interest rate of 5.3 % (3.6 %), a core (periphery) household savings ratio of 16.7 % (14.8 %) and a ratio of periphery to core real wage rate of 55 % are reproduced by autarky model solutions. 1987-1997 average government expenditure quotas and debt-to-GDP ratios are taken from the AMECO data base.
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Acknowledgments
A former version of this paper was presented at the 40th Annual Conference of the International Atlantic Economic Association in Vienna and in the Economics and Business Seminar at the Babes-Bolyai University in Cluj-Napoca. I am particularly grateful to Cristian Litan from the Faculty of Economics and Business for his perceptive comments.
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Farmer, K. Financial Integration and EMU’s External Imbalances in a Two-Country OLG Model. Int Adv Econ Res 20, 1–21 (2014). https://doi.org/10.1007/s11294-013-9442-z
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DOI: https://doi.org/10.1007/s11294-013-9442-z