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Prof. Paul McNelis (Fordham University, USA): TARGET balances and macroeconomic adjustment to sudden stops in the euro area

co-authored by Gabriel Fagan (Trinity College and ECB)


This paper examines how membership of a monetary union affects macroeonomic 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 overborrowing, leading to an increased incidence of sudden stop episodes.



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