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TARGET Balances and Macroeconomic Adjustment to Sudden Stops in the Euro Area

Gabriel Fagan
Paul D. McNelis

IIIS Discussion Paper No. 465

This paper examines how membership of a monetary union affects macroeconomic adjustment of Euro Area countries to sudden stops. We focus on a key difference between a standard peg and a monetary union: the availability of external financing from the common central bank via the TARGET system. For this purpose, we use a modified version of the Mendoza (2010) model which incorporates central bank financing, based on an empirical analysis of TARGET flows. Our results show that the availability of such financing greatly mitigates the collapse in GDP, consumption and investment during sudden stops (relative to a regime in which such financing is not available). However, a welfare analysis shows that TARGET financing only results in modest welfare gains in the affected country, since it exacerbates the tendency towards over-borrowing, leading to an increased incidence of sudden stop episodes.

JEL Classification: E52, E62,F41

Non Technical Summary
This paper examines how central bank financing in a monetary union affects macroeconomic adjustment to sudden stops in private capital flows. We first document that a number of stressed euro area countries (Greece, Spain, Ireland, Italy and Portugal) experienced sudden stops during the recent financial crisis. We then show how private capital outflows were compensated by liquidity provision by the Eurosystem, reflected in balances in the payments system (TARGET) (Trans-European Automated Real-time Gross Settlement Express Transfer). To examine the impact of the TARGET system on macroeconomic adjustment, we modify a workhorse model of sudden stops by incorporating a version of the TARGET system. We model the operation of the this system based on empirical analysis of the relationship between TARGET balances and interest rate spreads.  Our results show that a TARGET system greatly diminishes the effects of sudden stops on domestic demand, output and current account balances. However, the gain in welfare is small because of a reduction in precautionary saving which leads to an increased frequency of sudden stop episodes.

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Last updated 8 January 2015 by IIIS (Email).