Fornaro, Luca2021-10-072021-10-072022Fornaro L. A theory of monetary union and financial integration. Rev Econ Stud. 2022 Jul;89(4):1911-47. DOI: 10.1093/restud/rdab0570034-6527http://hdl.handle.net/10230/48584Since the creation of the euro, capital flows among member countries have been large and volatile. Motivated by this fact, I provide a theory connecting the exchange rate regime to financial integration. The key feature of the model is that monetary policy affects the value of collateral that creditors seize upon default. Under flexible exchange rates, national governments can expropriate foreign creditors by depreciating the exchange rate, which induces investors to impose tight constraints on international borrowing. Creating a monetary union, by eliminating this source of currency risk, increases financial integration among member countries. This process, however, does not necessarily lead to higher welfare. The reason is that a high degree of capital mobility can generate multiple equilibria, with bad equilibria characterized by inefficient capital flights. Capital controls or fiscal transfers can eliminate bad equilibria, but their implementation requires international cooperation.application/pdfeng© The Author(s) 2021. Published by Oxford University Press on behalf of The Review of Economic Studies Limited. This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs licence (http://creativecommons.org/licenses/by-nc-nd/4.0/), which permits non-commercial reproduction and distribution of the work, in any medium, provided the original work is not altered or transformed in any way, and that the work is properly cited.info:eu-repo/semantics/articlehttp://dx.doi.org/10.1093/restud/rdab057Monetary unionsInternational financial integrationExchange ratesOptimal currency areaCapital flightsEuro areaExternal constraintFiscal unionsinfo:eu-repo/semantics/openAccess