Fragmented Monetary Unions

• Authors: Luca Fornaro.
• BSE Working Paper: 110908 | April 24
• Keywords: Capital flows , unconventional monetary policies , euro area , inflation , Monetary unions , fragmentation , optimal monetary policy in openeconomies , fiscal crises , endogenous breaking of symmetry , optimum currency areas
• JEL codes: E31, E52, F32, F41, F42, F45
• Capital flows
• unconventional monetary policies
• euro area
• inflation
• Monetary unions
• fragmentation
• optimal monetary policy in openeconomies
• fiscal crises
• endogenous breaking of symmetry
• optimum currency areas

We provide a theory of financial fragmentation in monetary unions. Our key insight is that currency unions may experience endogenous breakings of symmetry: that is episodes in which identical countries react differently when exposed to the same shock. During these events part of the union suffers a capital flight, while the rest acts as a safe haven and receives capital inflows. The central bank then faces a difficult trade-off between containing unemployment in capital-flight countries, and inflationary pressures in safe-haven ones. By counteracting private capital flows with public ones, anti-fragmentation monetary programs mitigate the impact of financial fragmentation on employment and inflation, thus helping the central bank to fulfill its price stability mandate.