Capital market imperfections and the theory of optimum currency areas

This paper studies how within- and cross-country capital market imperfections affect the welfare effects of forming a currency union. The analysis considers a bank-only world where intermediaries compete in Cournot fashion and monitoring and state verification are costly. The first part determines the credit market equilibrium and the optimal number of banks, prior to joining the union. The second part discusses the benefits from joining a currency union. A competition effect is identified and related to the added monitoring costs that banks may incur when operating outside their home country, through an argument akin to the Brander-Krugman “reciprocal dumping” model of bilateral trade. However, in our framework, whether joining a union raises welfare of the home country is ambiguous; it depends on the relative strength of “investment creation” and “intermediation diversion” effects.

► Paper studies how capital market imperfections affect welfare effects of forming a currency union. ► Competition effect is identified. ► Related to monitoring costs that banks incur when operating outside home country. ► Whether joining a union raises welfare of the home country is ambiguous.