Asymmetric-shocks-on-its-head and lender-of-last-resort theories of optimal currency areas

Buiter, Willem and Sibert, Anne (2008): Asymmetric-shocks-on-its-head and lender-of-last-resort theories of optimal currency areas. Published in: Common Currency and Its Future: Lessons for the New Member States : pp. 48-61.

Abstract

We propose two new criteria to evaluate the appropriateness of a country joining a larger currency area. The first, asymmetric-shocks-on-its-head, argues that asymmetric shocks to real GDP provide an argument for adopting a common currency. The argument comes in three steps.

First, independent monetary policy and a floating nominal exchange rate are not effective instruments for mitigating the consequences of asymmetric GDP shocks. Second, standard portfolio diversification arguments imply that the more asymmetric GDP shocks are, the greater the benefits from international portfolio diversification. Third, portfolio diversification is encouraged by having a common currency.

The lender of last resort theory of OCAs starts from the observation that even a solvent bank can be brought down by a depositor run or market run. The central bank has to be able to act as lender of last resort and market maker of last resort. When much of the balance sheet of the central bank is denominated in foreign currency, the survival of banks faced with funding liquidity or market liquidity problems requires either a foreign currency lender of last resort or a domestic currency that is also a global reserve currency. There are but two serious global reserve currencies today: the US dollar and the euro.

Both refinancing risk and solvency risk due to a large depreciation of the zloty can therefore be avoided only by Poland adopting the euro and gaining access to the lender of last resort and market maker of last resort facilities of the Eurosystem.

• Item Type: MPRA Paper
• Language: English
• Keywords: Optimal currency areas Lender of last resort Asymmetric shocks
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; F - International Economics > F3 - International Finance; F - International Economics > F3 - International Finance > F36 - Financial Aspects of Economic Integration; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Santos Silval, J.M.C. and Silvana Tenreyo (2010) "Currency Unions in Prospect and Retrospect", Annual Review of Economics,2:51–74