Financial heterogeneity and monetary union

BIS Working Papers  |  No 1107  | 
04 July 2023



In March 2010, euro zone investors lost trust in the so-called periphery countries, precipitating a sharp pullback of private capital from the region. Although the periphery subsequently endured notable disinflation, a significant gap between the price levels in the core and periphery persisted during the ensuing crisis. As a result, real effective exchange rates in the periphery remained above those of the core countries, impeding the necessary economic adjustments.


We explain the slow adjustment in the price levels between the core and periphery by introducing financial frictions and customer markets into the conventional international macroeconomic model. Specifically, firms operate in customer markets, both domestically and abroad, and foreign and domestic financial markets are subject to a differing degree of distortion. In such an environment, firms from the core – with relatively unimpeded access to external finance – have an incentive to expand their market share at home and abroad by undercutting their periphery competitors, especially when the latter are experiencing financial distress. Firms from the periphery, in contrast, have an incentive to increase markups to preserve internal liquidity, even though doing so means forfeiting some of their market share in the near term.


The interaction of financial frictions and customer markets helps explain several aspects of the euro zone crisis that are difficult to reconcile using standard models. First, the pricing mechanism implied by this interaction is consistent with the empirical evidence, which shows that the acute tightening of financial conditions in the euro area periphery between 2008 and 2013 significantly reduced the downward pressure on prices arising from the emergence of substantial and long-lasting economic slack. And second, the tightening of financial conditions during this period is strongly associated with a notable increase in markups in the euro zone periphery, which is exactly the pattern predicted by the model.


During the 2010–12 eurozone crisis, deviations of price and wage dynamics from those implied by canonical Phillips curves were systematically related to differences in financial strains across countries. Most notably, markups in financially "weak" (periphery) countries rose, while those in financially "strong" (core) countries declined. In a monetary union model, where financial frictions interact with the firms' pricing decisions because of customer-market considerations, firms in the periphery maintain cashflows in response to an adverse financial shock by raising markups in both domestic and export markets, while firms in the core reduce markups, undercutting their financially constrained competitors to gain market share. In this framework, a unilateral fiscal-devaluation-style policy by the periphery stabilizes the local economy by improving the condition of firm balance sheets and by boosting household demand-it does not, however, reverse the real exchange rate appreciation in the periphery.

JEL classification:  E31, E32, F44, F45

Keywords: eurozone, financial crisis, monetary union, customer markets, inflation dynamics, markups, fiscal devaluation