a situation where changes in aggregate demand and/or supply differ from one country to another
Sometimes economists argue that capital mobility can also compensate for the loss of
monetary autonomy and the absence of exchange rate adjustment among the members of a common
currency area. A distinction should be made here between physical capital (plant and machinery) and
financial capital (bonds, company shares and bank loans). In terms of cushioning a currency union from
asymmetric shocks, movements in physical capital can help by expanding productive capacity in countries
experiencing a boom, as firms in other member countries build factories there. However, given the long
lags involved in the installation of plant and equipment, physical capital mobility is likely to be helpful
mainly for narrowing persistent regional disparities rather than offsetting short-term shocks.
shocks. For example, residents of a country experiencing a recession may wish to borrow money from
the residents of a country experiencing a boom in order to overcome their short-term difficulties. In our
two-country example, German residents would effectively borrow money from French residents in order
to make up for their temporary fall in income. Clearly, this would require that German residents can easily
CHAPTER 36 COMMON CURRENCY AREAS AND EUROPEAN MONETARY UNION
767
borrow from French residents through the capital markets, so that financial capital mobility will be highest
between countries whose capital markets are highly integrated with one another. For example, if a bank
has branches in more than one country of a currency union, then borrowing and lending between growth
and recession countries will be more or less automatic, as residents in the growth country increase the
money they are holding in the bank as their income goes up and residents of the country in recession
increase their overdrafts (or reduce their money holdings) as their income goes down.
We can relate this discussion back to the notion of permanent income, and to the market for loanable
funds. Recall that a family’s ability to buy goods and services depends largely on its permanent income,
which is its normal, or average income, since people tend to borrow and lend to smooth out transitory
variations in income. Now, when an aggregate demand shock adversely affects the German economy, a
large amount of German households will see their transitory income fall and will want to borrow in order to
increase income back up to the permanent or normal level. But since many German households are now
doing this at the same time, if borrowing is restricted to German financial markets, this will tend to raise
interest rates and generally make borrowing more difficult. If the market for loanable funds is restricted
to the domestic market, then we might expect the supply of loanable funds to decrease in a recession
and the demand to increase, raising interest rates. The resulting rise in interest rates may even make the
recession worse by reducing investment.
On the other hand, in France, the economic boom means that many households are experiencing
income levels above their permanent or average level, and so will tend to increase their saving. Now, if the
German households can borrow from the French households – if the market for loanable funds covers both
France and Germany – they can both consume at a level consistent with their normal or average levels of
income with less of an effect on interest rates. There will be an increase in the supply of loanable funds
because French residents are saving more and this will partly or even wholly offset the increase in the
demand for loanable funds arising from German residents who want to borrow more. When the German
economy comes out of recession and goes into recovery, German households can then repay the loans.
Of course, although we have discussed only bank loans, there are other forms of financial capital, such
as bonds and company shares, but the principle of the recessionary economy being able to obtain funds
from the booming economy remains the same. In effect, therefore, financial capital market integration
across countries allows households to insure one another against asymmetric shocks so that the variability
of consumption over the economic cycle can be reduced.
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